High Inflation: Impact and the Policy Response – Explained, pointwise

Introduction

India’s retail inflation rose to 7.8% in April, according to the latest data released by the Ministry of Statistics and Programme Implementation i.e., the general price level Indian consumers faced was almost 8% higher than it was in April 2021. This is the highest rate in the last eight years. It is also almost twice the inflation rate targeted by the Reserve Bank of India. Since October 2016, the RBI is required to maintain retail inflation at a level of 4%+-(2%) i.e., between 2%-6%. The RBI has responded by raising the interest rates in-between the scheduled MPC meetings. While most analysts have welcomed the RBI move, they also feel that more needs to be done to curb the inflation.

What are the recent trends in inflation?

Retail inflation has been high since October 2019 and has, in fact, touched the 4% mark just once since then. In all other months, it has regularly breached the 6% mark. April’s inflation is the seventh straight month when the inflation rate has gone up. India’s retail inflation rose by 7.79% in April and inflation in food items rose by 8.38%. However, the biggest jump was registered in fuel prices, which rose by almost 11% in April. Among the states, West Bengal, Madhya Pradesh and Telangana faced the highest levels of overall consumer inflation. The Wholesale Price Index has been in the double digits since April 2021.

What are the reasons behind high inflation?

Russia Ukraine Conflict: The ongoing conflict has created shortages of various commodities like wheat, oil and gas etc. The shortage has been created by disruption of supply chains due to the war hitting the exports from these 2 nations. Further, the series of sanctions imposed by the west on Russia has further enhanced the global prices of commodities.

Pandemic: In 2020-21, when the pandemic hit the economy, food prices rose by an even larger factor (7.3%) and the core inflation rose by 5.5%. The Supply chains were disrupted due the lockdowns. The demand has recovered but the supply has not been restored causing rise in prices.

Monetary Policy: According to the Dr. C Rangarajan (former RBI Governor), the lose monetary policy after the pandemic has led to excess liquidity in the economy, which has resulted in higher inflation.

Post Election policies: An eventual pass-through of the higher crude oil prices to domestic consumers started happening in late March after elections to five Assemblies were completed.

What are the impacts of high inflation?

Reduces people’s purchasing power: As per experts, the general price level at the end of 2022 would be around 25% higher than it was at the start of 2019. This would make things expensive and people would buy much less with similar income levels.

Decrease in Overall Demand: Consumers will demand fewer goods and services due to reduced purchasing powers. Typically, non-essential demands get curtailed while households focus on the essential items.

Harms Savers and Helps Borrowers:  High inflation eats away the real interest earned from keeping one’s money in the bank or similar savings instruments. Earning a 6% nominal interest from a savings deposit effectively means earning 0% interest if inflation is at 6%. By the reverse logic, borrowers are better off when inflation rises because they end up paying a lower “real” interest rate.

Helps the government meet debt obligations: In the short term, the government, which is the single largest borrower in the economy, benefits from high inflation. Inflation also allows the government to meet its fiscal deficit target. Fiscal deficit limits are expressed as a percentage of the nominal GDP. As the nominal GDP rises because of inflation, the same amount of fiscal deficit (borrowing) becomes a smaller percentage of the GDP.

Impact on Corporates: In the short term, corporates, especially the large and dominant ones, could enjoy higher profitability because they might be in a position to pass on the prices to consumers. But for smaller companies, persistently higher inflation will reduce sales and profitability because of lower demand.

Disproportionate impact on Poor: The poor are the worst affected because they have little buffer to sustain through long periods of high inflation.

Worsens Exchange Rate: High inflation means the rupee is losing its power and, if the RBI doesn’t raise interest rates fast enough, investors will increasingly stay away because of reduced returns. For instance, as of May 12, the return on a 10-year Government of India bond was 7.2%. But with inflation at 7.8%, this implies a negative rate of return. In order to prevent the country from adverse impact of inflation, the Reserve Bank of India had already announced a surprise hike of 40 basis points in repo rates on May 4.

How does an increase in interest rates reduce inflation?

Lowers Future Inflationary Expectations: The Central Bank by credibly committing to bring down inflation through aggressive current actions can bring down expectations of future inflation. If that happens, then demand would be pushed back, alleviating current inflation.

Attract Foreign Investment: Higher interest rates attract foreign capital that appreciates the currency, lowering import prices and, in turn, inflation.

Curbing Credit Growth: Higher interest rate raises both the cost of borrowing as well as its availability. This reduces credit growth, lowering demand, GDP growth and, eventually, inflation.

What are the challenges associated with RBI’s interest rate hike?

Outflow of Foreign Investment:  The Sensex has lost 4,045 points, or 7%, over the last seven trading sessions as FPIs withdrew a net of Rs 23,670 crore since the interest rate hikes by RBI on May 4.

Reducing Profitability of Companies: A spike in interest rates will affect the margins of listed entities. Higher interest rates will raise the cost of funds for companies thereby hurting their profitability in coming quarters.

Anticipated tightening by Federal Reserve: The intended outcome of an interest rate hike will get diminished provided an interest rate hike is announced by the Federal Reserve.

Already Slow Credit Growth: Having recovered from being negative in mid-2021, real credit growth is running just around 2%. This means a rate hike can further impede this miniscule credit growth and reduce GDP growth rate.

Limited Impact on Inflation: Many economic experts have opined that the present high inflation is more due to supply constraints, rather than high demand. In this context, the increase in interest rates might have a limited impact in bringing down inflation.

What should be done?

First, the RBI can raise interest rates in a credible fashion if high inflationary pressure continues. However, given that the economy is still recovering from external shocks, high interest rates may reduce the growth. It could lead to a situation of stagflation.

Second, bringing down present high inflation requires a resolution of geopolitical tensions in Europe, a much stronger fiscal support from the government, and reforms that help repair the disrupted domestic supply chain. Monetary Policy measures alone may be insufficient to rein-in the inflation. 

Third, the government can also enter into special agreements to combat inflationary pressures. For instance, India secured Russian crude oil in the face of sanctions, reportedly on offer at a discount of $20-30 per barrel.

Conclusion

An effective balancing of fiscal and monetary policy by the government is the most prudent way to tackle the growing inflationary pressure on the Indian Economy that would help in keeping the inflation level in the ideal range of 2-4%.

Source: Indian Express, Indian Express, Indian Express, Indian Express, The Hindu