A close look at the anatomy of India’s current price instability shows why our central bank being behind the curve is so risky
The inflation problem can no longer be ignored. Price pressures have spread across the economy—and there are few signs right now that they will abate soon. The Reserve Bank of India (RBI) has begun to tighten monetary policy without explicitly saying so. Many companies have indicated that they will increase their product prices. The government’s decision to provide free food for another six months could at least partly be explained by the need to protect the purchasing power of households.
It is useful right now to look more closely at Indian inflation, beyond the headlines. There are five issues worth focusing on.
First, inflationary pressures have been lying in wait for far longer that most people realize. The sharp drop in headline inflation in September 2021 may also have created a false sense of security. It began climbing soon after. The average numbers over the past year tell a more worrisome story. Headline inflation has averaged 5.5% since April 2021. Average core inflation—which excludes volatile food and fuel prices—has been even higher at 6%. Other measures of core inflation, which exclude the prices of petrol, diesel, gold and silver, have also been flashing amber. So, even though the discussion after every monthly data release looks at the impact of a few individual items in the consumer price index, the broader story is that inflation has been sticky. Why core inflation has been persistently high despite weak demand is an analytical puzzle that economists have not yet convincingly answered.
Second, inflation has not been restricted to a few items. In the US, those who argued that the price pressures in that country were transitory because they were concentrated in a few areas such as used cars and timber have now seen inflation spread. It is much the same story in India. There are various measures to show widespread price pressures are across the Indian economy. One such measure is the trimmed mean. The outliers in the price index, or the items that have seen the largest and least price increases, are removed from the calculation. Various trimmed means in India show that price pressures are not concentrated in a handful of items that have been hit by idiosyncratic demand or supply shocks. It is much the same with diffusion indexes, which calculate the proportion of items that drive the rise in any index, such as the one for consumer prices.
Third, the drivers of inflation in India are worth examining. Recent inflation has generally been fuelled by goods inflation rather than services inflation. This is true of many other countries where demand for goods recovered faster than demand for services, and that could change as consumers begin going out with greater confidence. A sharp rise in hotel prices is one early indication. The other way to look at the drivers of inflation is to see whether pressures are coming from the supply or demand side. In its latest monetary policy report released earlier this month, the Indian central bank has used a statistical technique called vector auto regression to show that consumer prices are being pushed up by factors such as oil prices, higher money supply, rural wages, domestic supply constraints and rupee depreciation. Weak demand is working in the opposite direction, to keep inflation down. Finally, the role of imported inflation is growing in importance, which is no surprise given the resurgence of inflation in most advanced economies and the sharp increase in global commodity prices.
Fourth, where does India stand compared to other major economies on the inflation front? Much is made of the fact that US inflation is now higher than Indian inflation, but a wider look tells us a more sobering story. The Economist tracks the latest data from 42 major economies every week. There are 17 countries which have higher inflation than us, but 24 countries with lower inflation. So while India is not a global inflation outlier, as it was a decade ago, it is not a safe zone either. However, each country has its own macro fundamentals, and a more useful measure that I prefer is how far inflation in any country has drifted away from its formal or informal inflation target. This exercise can only be done with data from countries where central banks have numerical inflation targets, but it shows India in a better light. As this column pointed out two weeks ago, there are three groups of countries. The first group comprises countries such as the US, Brazil, Germany, Mexico and the UK, where the most recent inflation reading is way above target. The second group has countries such as France, South Korea, Taiwan and South Africa, where inflation is slightly above comfort levels. And then there are countries where inflation is still below target. These countries include Japan, China, Indonesia and the Philippines.
Fifth, Indian monetary policymakers have to look at two other measures of inflation as well: inflation expectations and the forecast of future inflation. Inflation expectations have been drifting up in India for some time. Think of this as inflation psychology in the country. The central bank has also increased its inflation forecast for the new fiscal year that began on 1 April. RBI had said in February that it expected inflation to average 4.5% in fiscal 2022-23; that forecast has now been raised sharply to 5.7%, though the central bank still expects quarterly inflation to sequentially come down over the year.
The inflation forecast is important because a central bank has to design policy by looking through the windshield rather than the rear-view mirror. The reason: Monetary policy operates with a lag of three or four months, so what RBI does now will only have an effect a year or so down the line. That is why our central bank being behind the curve is now risky.
Niranjan Rajadhyaksha is CEO and senior fellow at Artha India Research Advisors, and a member of the academic advisory board of the Meghnad Desai Academy of Economics.