Home >Markets >Mark To Market >The hidden reason behind RBI's calm in the face of inflation

Over the past several months, the talk of the town has been inflation.

A retail inflation level of above 6% has already begun to worry markets but is yet to show a visible concern from the Reserve Bank of India. So what could be behind the seeming calm of the central bank on this front? Economists believe that the reasons are not restricted to the obvious arguments of supporting a budding recovery amid a pandemic that refuses to go away.

One key reason for keeping governor Shaktikanta Das from pressing ahead on inflation is the divide between the formal and informal sectors in the economy. “There is no debate that inflation is up. The debate is how much is the gap between the demand as shown in the formal sector and that of the informal sector. The question also is how much of demand-led inflation can the formal sector bring in," said the chief economist of a foreign bank, requesting anonymity.

Much of the high-frequency economic data represents the formal economy comprising predominantly large listed producers and service providers. The scores of small businesses and mom-and-pop shops that form the non-farm informal sector have been bruised beyond repair. Economic shocks have hit the informal sector disproportionately due to the low or the lack of financial buffer.

The weakening of the informal sector throws up two big challenges for RBI. One is the distress on employment and incomes, which may drag down demand. In an exhaustive report on the informal sector, analysts at HSBC point out that while agricultural wages have stood firm, those on non-farm employment in rural India have moderated. “Unlike agricultural wages, non-agricultural wages in rural India have not been as resilient. We find the wages of the two groups can diverge for an extended time as they have different drivers," the report said. HSBC analysts add that this cohort may have borne the brunt of covid the most. Low wages would mean low pricing power and weaker terms of trade. What’s more is the hit to business in the informal sector from the large formal firms. Large companies have weathered the pandemic and even flourished despite it as they ate into the share of small firms.

The second challenge for Das is that much of the inflation has emerged from the supply side. The key driver of the increase in headline retail inflation is government taxes on fuel, and the rest is largely imported inflation due to a sharp rise in global commodity prices. Monetary policy is not effective in curbing these price pressures. That said, supply-side inflation has the potential to trigger a wage spiral through which inflationary pressures get entrenched. When workers expect prices to go up, they tend to negotiate higher wages. The prospects of this are limited currently simply because of the unequal terms of trade in different sectors. The upshot is that there is enough probability for the current inflation to be transitory.

That gives Das room to remain focused on growth this time, too, citing the still wide slack in the economy and nascent recovery. “Forward guidance will favour a continuation of the accommodative policy stance to guard against growth risks, especially the third covid wave. The accompanying commentary will heed inflation risks through close monitoring and refrain from tweaking the policy levers for now," Radhika Rao, an economist at DBS Bank, wrote in a note.

Meanwhile, the threat of another wave and a moderate vaccination pace adds weight to the central bank’s growth-centric approach. So the test for RBI is to figure out how long can policy be ultra-accommodative without lighting a fire under inflationary expectations.

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