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Photo: PTI
Photo: PTI

The challenge of inflation amid a massive shock to our economy

Persistent price pressures make it harder for our central bank to manage conflicting economic forces and ensure stability

ndia is once again a global inflation outlier. Only three other major economies have consumer prices growing at a faster clip—Turkey, Pakistan and Argentina. This has been so for many months now. Indian consumer price inflation has averaged 6.7% in the first seven months of 2020, well above the upper end of the inflation target range. Most large Asian economies have far lower inflation rates. Malaysia, Singapore, South Korea, Taiwan and Thailand were in deflation territory in July. This is based on macroeconomic data from 42 countries published every week by The Economist.

A second inconvenient fact is that India is one of the few large economies where inflation has actually gone up since the start of the pandemic. The Philippines is the only other such country. The increase in Indian inflation has only been around 30 basis points since February, but it must be read in conjunction with the collapse in economic activity in the first quarter of the current fiscal year. Even countries such as Argentina and South Africa that are prone to high inflation have seen price pressures ease during the pandemic.

A few economists have already termed this toxic mix of high inflation combined with falling output as stagflation. It is likely that inflation will begin to come down in the second half of the fiscal year, especially given the expectations of a record summer crop. However, the unlikely persistence of inflation still deserves attention, particularly because it could potentially constrain future policy responses by the government as well as the central bank. Chetan Ghate, a member of the outgoing monetary policy committee, has mentioned the possibility of an “inflation whipsaw": “On the upside, a perfect storm of cost push pressures, accommodative monetary policy, and adverse food supply shocks could lead to a pickup in inflation. On the downside, the paradox of thrift, i.e., forced saving pressure induced by a ‘de-facto’ lockdown, could be a potent disinflationary force."

There are four competing explanations of why inflation has been surprisingly persistent in the past few months. First, there is the possibility that the supply dislocations during the national shutdown have been more severe than the demand destruction over the same period. So not enough goods have been able to reach markets even to satisfy lower demand for them. High-frequency data shows that transport services are still taking time to normalize.

Second, a whole host of idiosyncratic factors have added to India’s inflation number—from rising gold prices to tax increases on fuel to upward-bound liquor prices. And food inflation was pushed up by higher prices of select farm produce such as potatoes and tomatoes. However, there do seem to be broad-based price pressures even after these specific factors are ignored.

Third, the central bank’s accommodative monetary policy is feeding inflation. The latest data from the Reserve Bank of India (RBI), for the week ended 14 August, shows that reserve money grew by 14.7% while the stock of broad money grew by 12.6%. The recent monetary expansion comes after several years of single-digit growth in monetary aggregates, especially driven by an increase in foreign exchange reserves. The inflationary impact of such monetary expansion may be muted for now because of a massive expansion of currency demand (23.1%) rather than bank deposits (10.8%).

Fourth, some of the inflation is because of higher prices of imported goods. The Indian central bank hinted at this possibility in a recent statement on a new round of its operation twist, though it left many puzzled in financial markets. “The recent appreciation of the rupee is working towards containing imported inflationary pressures," it stated. Traders interpreted this as a signal that the central bank would allow the rupee to appreciate.

The country’s central bank has once again got to choose between targeting the exchange rate or money supply, given India’s largely open capital account. The deluge of foreign money that has come into India in recent months, combined with a narrowing current account deficit, means that the private sector has been unable to absorb the foreign exchange inflows. RBI has been forced to buy dollars to prevent the rupee from appreciating. This has added $67 billion to its war chest since April, exacerbating the excess liquidity that is already sloshing around in the domestic money market, even after sterilization through bond sales.

In an insightful report on the exchange rate management strategies of the Indian central bank since the early 1990s, Barclays economists Rahul Bajoria and Shreya Sodhani write that RBI is now likely to go by its 1999 playbook—of keeping the rupee weak despite strong capital inflows as well as a balance-of-payments surplus. This is in contrast to other historical episodes when the Reserve Bank decided not to absorb all the excess capital inflows, but instead let the Indian currency appreciate against the US dollar.

The coming months will present RBI with many challenges, as the central bank has to maintain both internal as well as external stability in the midst of a massive shock to the economy.

Niranjan Rajadhyaksha is a member of the academic board of the Meghnad Desai Academy of Economics

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