Surging inflation has little demand pull for the central bank to respond
- RBI has committed to keeping its policy loose and has also stressed on the need to support growth
- The monetary policy committee has recommended that the government prune taxes
Inflation is on its way up for India. In other parts of the world, price pressures have already reached uncomfortable levels. Retail inflation in the US spiked to a 13-year high in May.
Back here, retail inflation was 4.29% in April but is expected to rise in coming months. The Reserve Bank of India (RBI) expects retail inflation to average 5.2% for FY22, higher than its medium-term target of 4%. Yet, the central bank has not made any noises about withdrawal of policy accommodation. In fact, RBI committed to keep its policy loose and stressed the need for supporting growth. The upshot is that the central bank doesn’t seem to be worried about inflation even though investors have begun to fret. Why is that?
In a 27 May note, analysts at HSBC Securities and Capital Markets India Ltd pointed out that the rise in inflation is different this time. Both the wholesale price index (WPI) and purchasing managers’ index show that input prices have surged but output prices have not. “Producers do not seem to be passing much of the rise in raw material costs to output prices, perhaps worried that the already uncertain demand could weaken further,” they wrote.
Indeed, the second wave has hit consumption again and worries over a possible third wave are already visible among policymakers. This perhaps is the crux of RBI’s hesitancy to respond to an uncomfortable inflation situation. There isn’t enough pull from the demand side that may require RBI to tighten its policy. Sure, producers would soon start passing input price increases to the end consumers.
HSBC analysts expect this pass through once demand begins to revive as lockdowns ease. But that is still some time away. “We argue, and with a reasonable degree of confidence, that countervailing forces in the form of a strong downdraft in food inflation, a negative output gap further limiting the pass-through from WPI to CPI (consumer price index) inflation, along with demand side price pressures remaining in abeyance for at least H1FY22 can counter the imminent upside risks to CPI inflation to a large extent,” economists at QuantEco Research wrote in a note.
Simply put, India’s factories still have enough idle capacity to meet the rise in demand for goods without large price increases. If food inflation rises again, monetary policy can do little to curb it. The antidote for fuel inflation seems to be a cut in taxes. Indeed, the monetary policy committee has recommended that the government prune taxes.
That leaves us with core inflation which responds to monetary measures. Most economists believe core inflation would surge in FY22 and HSBC predicts it to be 6% in the second half. Given India’s rural areas have been hit harder in the second wave, core inflation from these parts could rise similar to what was seen in urban areas in April and May last year.
For RBI though, the task is to limit the hit on growth through inflation. In other words, the central bank needs to manage the growth-inflation tradeoff. This hinges not only on how swift demand comes back, but also on how sticky this demand is.
For demand to become sticky, Indians need to be convinced that the outlook on employment and wages has improved. A sustained growth recovery is the only way this will happen. Economists believe FY22 won’t be a year of conviction on growth.
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