We recently had some routine economic data releases — high(er) consumer price inflation but lower GDP growth numbers. (Indeed, that combination has become routine!). At about the same time (earlier this month), the rupee also experienced some renewed downward pressure — dropping nearly 3 per cent to the 63.80 levels in a span of a couple of days.

Immediately, the RBI Governor came out with a statement (November 13) titled “No fundamental reason for rupee volatility”. The Governor gave various figures and estimates in that statement to support the RBI’s perception that fundamentals did not warrant the rupee’s renewed weakness.

That statement about the rupee also said: “the RBI is concerned about the weak economy as well as high inflation. We believe the weak economy, increases in food supply, and recent policy rate hikes will provide a disinflationary impetus over time, and recent data do not dispel this view. We will watch the incoming data carefully, especially looking for the effects of the harvest on food prices as well as the second round effects of fuel price increases and exchange rate depreciation, before we make further decisions on interest rates”.

You will not be wrong if you think this statement thoroughly lacks credibility. For, how long, have we heard the view that inflation would get curbed going forward. But, inflation does not show any sign of coming under control.

This statement, therefore, is no different for the regular reader of the RBI documents. But, it still is interesting for the technical point it makes about a weak economy generating a disinflationary impetus. Note that in the past, we had inflation rising in an economy expanding at about a 7 per cent rate. But, 2011-12, 2012-13 are seeing inflation rising in an economy growing at a vastly slower pace.

If a weak(ening) economy would generate disinflationary forces (as the RBI asserts in its November 13 statement), we are not seeing — and have not seen — any evidence of this. As the chart shows, inflation has remained high and stubborn with an upward bias even as the economy has noticeably cooled. Dis-inflation, therefore, is not evident in the recorded data.

So, how is the RBI confident now that the weak(ening) economy would deliver lower price level increases?

Role of expectations

The RBI is technically correct, of course, in saying that a weak economy could generate dis-inflationary forces and keep price pressures under control. That view is based on the logic that a weak economy leaves under/unutilised real resources. Weak utilisation of available resources, in turn, would apply downward pressure on the overall cost of producing goods and services. That is, at the aggregate level, it can be expected that the slack in the economy can lower the economy’s entire cost curve. And that, in turn, will result in lower final prices of goods and services.

That is the hope.

But, as has been turning out, that hope is not being realised.

Why?

One critical reason could be that inflation expectations are now so well entrenched and at such a high level that any softening in real costs of producing goods and services is not getting reflected in realised final prices (and, in turn, on realised price-level changes).

(It is also not certain that the weak economy has lowered overall production costs.)

Think of this situation in this manner.

Producers of goods and services in the economy will fix the selling prices of their products at the current juncture or time — to begin with — on the basis of their current real costs of production as well as the demand for their goods and services. But, in a high inflation situation, they will also take into account how their production costs and demand for their products will evolve between now and the next time they fix their selling prices.

When they expect high inflation to prevail and when they may not obtain too many opportunities to revise their selling prices, the tendency will be to factor in the “high expected inflation” into the prices they are fixing now. Higher the expected inflation, higher the current price that will be fixed.

Note that when the higher inflation expectations are realised (or exceeded), the business which has fixed its price at a “high” initial level may still be better off in “relative” terms compared to its competition.

That is, we broadly are reduced to a situation where

Current inflation => Real cost of production + expected inflation

Current inflation then rises as expected future inflation remains at a high level or worse, rises further.

Expectations Trap

Entrenched high inflation expectations are a difficult trap for the policy-maker. There is no easy way out. The policy-maker needs very high credibility to influence economic agents — producers, consumers, households — to change their perceptions and move to a lower inflation environment without too much damage to the real sector.

Does the RBI have the credibility? Do ordinary people believe that the RBI can make their everyday living relatively more affordable?

(The author is a Chennai-based financial consultant.)

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