When inflation dynamics complicates monetary policy

The Reserve Bank of India (RBI) surprised the street by holding policy rates steady during its December mid-quarter monetary policy review last week.

A 25 basis point repo rate hike was factored in by many, for Wholesale Price Index (WPI)-based inflation spiked to 7.5 per cent in November, and Consumer Price Index-based inflation came in at an intolerably high 11.2 per cent.

While the pause from the RBI was greeted as a welcome surprise, it also raised questions on the predictability of its policy actions. Governor Raghuram Rajan has been categorical that high inflation requires monetary action irrespective of its origin — supply or demand. Then why did he pause at this juncture?

Typically, central banks treat supply-side shocks (emanating from fuel and food) as noise and don’t factor them in policy decisions if they are believed to be transitory. In view of this, the RBI’s move to ignore the bump up in inflation due to a spike in vegetables prices (widely believed to be transient) was justified. But the same logic may not apply to other categories of food that have seen stubborn price fever for several years now, apart from high fuel and electricity inflation, which also is expected to persist.

This year, India is yet to reap the bonus of low inflation that generally comes with an above-normal, well-distributed monsoon, because overall food inflation surged to 20 per cent in November. The spurt in vegetable inflation, which rose to 92.5 per cent in November, has been the prime driver of food inflation.

Luckily, the usual suspects behind a high food inflation spiral such as pulses, edible oils and sugar are, in fact, seeing price declines or deflation this time around. But this has been more than offset by an extraordinary price increase in vegetables and a pick-up in cereal inflation. The result: high overall food inflation.

Monthly data of the last few years show that vegetable inflation has been the most volatile component of food inflation and each episode of spike is typically followed by an equally sharp fall when supply improves.

It is time for vegetable inflation to soften now and the December print should reflect that. And that’s why the RBI rightly ignored the fleeting surge.

Inflation in some other foodgrains, too, could head down with the arrival of bumper harvest which typically follows good monsoons. But the overarching concern on food inflation is that it has structurally moved up. To jog the memory, food inflation in the last eight years has averaged over 10 per cent compared with sub-5 per cent in the preceding decade.

This upward structural movement is a consequence of demand-supply mismatch, which has been accentuated by low productivity and inefficiencies in the system.

Taming of food inflation will require steps to improve the supply response, cutting wastages in perishables and tactical release of excess foodgrain stocks into the open market. Durable remedies putting a lid on food inflation need to be structural — that is, outside the orbit of monetary policy.

But high food inflation cannot be ignored by the RBI in its decisions as food constitutes almost 50 per cent of the average Indian consumption spend. As long as food inflation remains structurally high, monetary policy will have to remain vigilant ensuring it doesn’t become generalised — as seen in fiscals 2011 and 2012 when, along with food, manufacturing — or core — inflation, too, went up after a generous fiscal stimulus.

The situation is different this time because the economy is running below potential at sub-5 per cent compared with over 9 per cent in fiscal 2011. The pertinent data here is the sharp decline in private consumption growth to around 2 per cent from over 8 per cent during the fiscals 2011 and 2012. This weakness is also manifesting in disinflationary tendencies in the manufacturing sector, which is operating below capacity. And given the muted growth prospects and the inability of fiscal policy to push growth up, core inflation is unlikely to spiral up the way it did in those two years. The WPI-based core inflation had crossed 6 per cent in fiscal 2011 and touched 7.3 per cent in fiscal 2012. It is currently at 2.7 per cent.

To be sure, overall inflation is likely to come off in the months ahead, but not to levels that will permit the RBI to continue holding rates steady and later cut. The other worry is the elevated inflationary expectations. As the RBI notes in its December monetary policy review, high inflation at both wholesale and retail levels risks entrenching inflation expectations at unacceptably elevated levels, posing a threat to growth and financial stability. All of that implies that the central bank has limited freedom to support growth.

Interestingly, the RBI will release its new monetary policy framework soon, when it is expected to define a nominal anchor (inflation metric) for the conduct of monetary policy. That together with some other measures to improve transmission should make monetary policy more transparent and predictable.

Yet, the possibility of more policy surprises exists. As the economist Frederic Mishkin noted, “Monetary policy will always have elements of art as well as science.”