RBI must revise its inflation target range -- upwards

Statistically, the paper suggested the use of a New Keynesian Phillips Curve (NKPC) model, incorporating the inflation gap (with trend inflation), output gap and also an error term to represent unexplained determinants. Based on past experience, the paper assumed that actual inflation converges to the trend “after short term fluctuations die out." Even though this model incorporates protocols such as Markov Switching to segmentize inflationary epochs, it seems to bear an oversight.

Trend inflation frankly has no exposure to events such as covid lockdowns and the Ukraine crisis. These black swan events have fundamentally changed the economy in terms of permanent capacity destruction and nebulous consumer signalling. Therefore, assumptions pertaining to potential output and convergence in inflation gap may not hold true at times like this.

Unless RBI recalibrates the model with new data or rethinks the methodology, it is possible that the current inflation target rate “imparts a deflationary bias to monetary policy because it will go into overkill relative to what the economy can intrinsically bear in order to achieve the target," the paper states.

Looking at RBI’s Household Inflation Expectation Survey and Survey of Professional Forecasters (SPF), it is clear that inflation expectations do not indicate a transitionary narrative.

As per the October 2019 surveys, only 49% and 57.3% of household respondents expected prices to increase more than the then current rate over 3-month and 1-year horizons, respectively. Their proportion went up to almost 66.1% and 70.8% in the most recent June 2022 survey. Similar results are obtained from the SPF, whose maximum consumer inflation estimate has risen to 7.2%, as compared to 4% recorded before the crisis. Perhaps RBI’s intention of anchoring inflation expectations has not succeeded with its current target.

Essentially, inflation in India can be ascertained with the help of the Friedman monetary principal, which states that monetary expansion increases the nominal income of consumers, who in turn use it to consume. In the initial phase, this consumption results in inflation because aggregate demand surpasses the supply of goods. However, increased demand impacts the supply side, putting pressure on capacities. In turn, higher input costs such as enlarged wage bills hurt corporate margins. This double whammy causes inflation to find expression at both the output and consumer level.

Consumers initially do not take this price rise seriously and assume that prices will stabilize in the short term, so they temporarily hold back on consumption and increase their savings. Inflation tends to rise slower than money supply. Consumers, however, soon reorient their cash holdings towards consumption, reducing their savings. Consequently, inflation begins to rise faster than the currency in circulation (CIC).

Moreover, Keynes in his inflationary gap analysis proposed that crisis-driven public capital expenditure usually means front-loaded capex, which in turn causes aggregate expenditure to outstrip aggregate output, causing an inflation gap. This happens because the economy utilizes all available inputs, resulting in incremental money supply becoming savings. As supplies are yet to match demand, restrained consumption lurks in the background awaiting release.

Analysing India’s case, the government’s net borrowings expanded by over 150% in 2020-21 (revised estimates), and by over 120% in 2021-22, as compared to the budget estimates for 2020-21. As front-loaded public capex became paramount, RBI’s holdings of government securities rose significantly, expanding its balance sheet and increasing money supply.

In the initial phase of the crisis, consumers had suspended consumption and thus most of the incremental money supply returned to the system as savings. This caused the CIC to grow by just 7.2% in 2020-21. Inflation as a difference between current and constant gross domestic product (GDP) was roughly 5% that year. In the second phase, however, as consumers focused on consumption, CIC grew by 9.5%. ‘GDP deflator’ inflation, as a difference between current and constant GDP, was roughly 10.8% during this time.

The analysis portends that the Indian economy is now in the second phase under the Friedman principal and inflation will continue to outstrip expectations until: 1) government borrowings and hence capex is curtailed; 2) Interest rates are increased with impunity (Volcker moment); and 3) Taxes are increased to reduce incremental resources available with the public. But then, all three at this stage will likely ruin market sentiment and fiscal as well as monetary policies can at best reach a middle ground. Nevertheless, RBI must prepare for a considerably long haul of high inflation and therefore raise its inflation target range for the time being. Or so at least until it becomes clear how well the economy is recuperating from its recent shocks in the medium term.

Karan Mehrishi is an economics commentator and author of ‘The India Collective: What India is Really All About’