Price worries. Fight against inflation is not over

Inflation above a threshold level harms growth. Therefore, central banks are vested with price stability as the primary objective of monetary policy. In inflation-targeting countries, including India, controlling inflation expectations is the overriding objective.

In the post-Covid period, inflation was at a decades-high level in most countries. On the ground supply disruptions were causing high inflation, and most central banks delayed their policy action, which worsened the situation. As retail inflation was generalised, partly due to supply shock and more due to post-Covid pick-up in demand, central banks had no option but to raise policy rates rapidly.

Given the growth-inflation trade-off in the short run, while GDP growth has considerably slowed globally (see table), retail inflation, although softened modestly from its recent peaks, remains well above the target in many countries.

Central banks are less aggressive now with rate hikes typically limited to around 25 basis points at a time. Some central banks have paused, but are not confident about inflation reverting to target anytime soon. There is an ongoing debate on whether central banks have reached the peak policy rates. The issue under consideration is whether the fight against inflation is over.

Policy rate cycles are typically asymmetric. While policy accommodations are rapid, policy tightening is generally slow and calibrated. This time, the policy responses to control inflation were rapid mainly due to the policy rate remaining at zero lower bound, especially in many developed countries and liquidity overhang was unprecedented globally due to Covid-related compulsion.

The sacrifice of growth is inevitable, but it may not be too large. The soft landing of the US economy looks most probable. The labour market is still tight with the US unemployment rate hovering around 3.5 per cent since March 2023 — much below the natural rate of unemployment at 5 per cent.

The US Fed has not given any indication of having reached the peak policy rate. As against the medium-term target of 2 per cent, the recent softening of the US retail inflation to 3.2 per cent, although significant, is partly due to the high base.

The expected growth slowdown in the UK and EU is more alarming. The July retail inflation in the UK at 7.9 per cent and EU at 5.3 per cent remains elevated as against the target of 2 per cent. In these jurisdictions, the prevailing nominal policy rates are lower than the inflation rate.

Central banks in these countries face a serious policy dilemma. With a negative real policy rate, it is not advisable to loosen the fight against inflation despite a high probability of recession. China seems to be an exception with negative inflation despite significant recovery. Barring China, other major economies are still behind a peak policy rate. Even Japan’s negative policy rate seems untenable in the context of a recent surge in the inflation rate.

India’s resilience

India’s growth story is different with remarkable resilience despite strong global headwinds. The IMF’s recent projection of India’s real GDP growth at 6.1 per cent in FY24 compared to RBI’s projection of 6.5 per cent is certainly a source of comfort for RBI to remain focused on the withdrawal of excess liquidity and sustain the stance of monetary policy.

Despite a pause in the repo rate consecutively for the third time, the RBI has yet to give any indication that it has reached the peak policy rate in this rate-hike cycle.

Viewed from the angle of growth resilience, India’s aggregate consumption demand is likely to be sustained. Similarly, given the high-capacity utilisation, private investment is expected to pick up. The much-awaited virtual investment cycle is expected to materialise through private investment crowding in due to sustained public investment.

Amidst global uncertainty, as the domestic growth scenario is optimistic and probably close to its potential, the RBI’s resolve to control inflation expectations is the need of the hour.

The inflation outlook is still a major concern. The July CPI inflation at 7.4 per cent has again breached the RBI’s tolerance limit of 6 per cent after four consecutive months of retail inflation within the tolerance band. Even if current inflation is transient mainly due to high food inflation (11.5 per cent), India’s average CPI inflation in FY24 may be around 6 per cent despite expected relief in Q4 of FY24 due to the base effect.

The real policy rate, which was modestly positive since February 2023, has turned negative. Although the policy dilemma is not severe in India, it is difficult to bring down retail inflation to a medium-term target of 4 per cent within a year without policy intervention.

Besides liquidity overhang in the post-Covid period, commercial banks are flush with funds for two more reasons — large transfer of RBI profit to the government and withdrawal of ₹2000 notes, the bulk of which is deposited in banks. Instead of open market sale of securities, the RBI preferred to impose a 10 per cent incremental CRR to mop up excess liquidity.

This would additionally keep the benchmark G-Sec yield under control. More action may be needed like the sale of foreign exchange as and when the rupee depreciates. Withdrawal of excess liquidity is a must for enhancing the transmission of recent rate hikes to the economy.

The writer is currently RBI Chair Professor at Utkal University and former Head of the Monetary Policy Department, RBI. Views expressed are personal.