Repo rate can’t fix food-driven inflation

By the time the Monetary Policy Committee (MPC) meets next week and decides on the repo rate and attendant measures to deal with inflation, the CPI data for July would not have been published. So, the MPC will in all likelihood analyse, among other things, the data for June which indicated inflation to be at 4.81 per cent, the highest so far this financial year.

The spike in the June imprint is attributed to elevated food prices. Analysis by ICRA now indicates that the July data could be even higher at 5.3/5.5 per cent as vegetable prices are ruling firm. Therefore, the MPC which “believes” that its interest rate decisions are impactful on inflation may either choose to tighten or continue with a pause. But it is likely to be guided by the CPI-uppishness.

The MPC resolution of June 8 stated that CPI inflation is projected at 5.1 per cent for 2023-24 with the fan-chart showing the risks as evenly balanced. The MPC chairperson further stated that “.. anchoring of (inflation) expectations is underway and that our monetary policy actions are yielding the desired results”. This means that the MPC is convinced its actions are yielding results.

However, it is well known that the MPC’s rate actions failed to achieve the desired results during three straight quarters in 2022 whereupon a confidential report was sent to the government.

The larger point revolves round the effectiveness of the instrument of repo rate hikes in dealing with inflation in the Indian context. It has failed in achieving its objective earlier and latest reports on the impact of the recent repo rate hikes (250 basis points increase since April 2022 ) reveal the cost-push effect it has had on corporates. An analysis by a business daily says the interest cost of a sample of listed corporates had gone up by 35 per cent consequent to the MPC rate actions. This would of course have impacted earnings negatively.

If the upside risks to inflation from monsoon tantrums, geopolitical developments, global oil prices, materialise during the current fiscal too, it would further underline the fact that repo rate increases need not succeed. One fondly hopes that such a prospect does not arise, but hope is no strategy. On the other hand, the deleterious effects of rate actions and the drag-effect on “growth”, would stand exacerbated.

There is enough ground to hypothesise that with CPI as the reference for inflation targeting, the MPC may be ill-equipped to achieve its objective. The weightage for food articles in the CPI is about 46 per cent. Food price movements are driven by supply-side factors. Any relationship between actual or inflation “expectations” as reflected in the price movements of vegetables, and the repo rate, is at best, tenuous. Theoretically, if the entire movement in CPI is driven by food prices, then what would the MPC be able to do, repo rate being its only tool?

Even our fuel prices (weightage about 8 per cent) are determined by international crude prices. If crude were to become costlier thanks to geo-political reasons, not only are interest rate hikes not going to control pump prices, they may add to the cost-burden. Thus 54 per cent of the CPI, at the minimum, is not amenable to any repo rate tinkering.

On the other hand, what a repo rate hike is guaranteed to achieve is increase borrowing costs for both the Centre and States, an indirect tax on all.

Also, the CPI composition itself has come in for flak lately. The Chairman of the Economic Advisory Council to the PM, Bibek Debroy, likened it to an antique store. “We continue to monitor a basket of goods that includes torches, radios, tape recorders, CDs, DVDs, audio/video cassettes, and trunks, among some 300 other items. Although these have a minimal weight in the overall CPI calculation, we are clinging onto the past, tracking items that no longer hold the same relevance in our consumption patterns,” he wrote in an article in The Hindu.

Large informal sector

The other major factor which should weigh with us while discussing the repo rate-CPI inflation interplay is the extent of the informal sector in the Indian economy. While the advanced economies like those of the US, Euro area, UK and Japan have very tiny informal sectors (contributing less than 10 per cent of GDP), in India the Indian informal sector is assessed at 43 per cent (worldeconomics.com)

Yes, the repo rate can impact the formal sector, albeit with lags but the MPC does not affect the informal sector at all. The financial agents of the informal sector operate on their own, far removed from the world of repo rates, LTROs, accommodative stance, etc. The responsiveness of the formal sectors, particularly housing in the US, to interest rate changes is high. In the US, food has a lower weightage. It is interesting that US Fed Chief Jerome Powell should refer to interest rates as “famously blunt tools”. The US remains a non-inflation targeting country, unlike the UK or Japan.

The other risk in the template before the MPC is the “Law of the Instrument/the Law of the Hammer” as articulated by Abraham Maslow. There could be a bias in favour of the MPC using the repo even if it is recognised that it will not be effective, or indeed counterproductive.

What indeed could be an alternative for targeting by the MPC? May be a measure of liquidity (as assessed by M3 or broad money estimate) with due regard to the growth projections which are anyway articulated indirectly through the Union Budget in advance. In other words, the MPC could be made responsible for ensuring just the right quantum of (target) liquidity (the repo rate could be one of the tools), premised on the government’s budgeted growth projections for the year.

Then who will control prices/inflation? The government of the day as far as prices of fuel and food (essential items) are concerned. Liquidity management by the MPC will address broadly (not specifically) the rest of the items in the CPI basket. In any case, it is the government that is finally accountable to the people. So why vest MPC with a task which is truly beyond its capacity? Isn’t it time for a re-look at the MPC mandate itself given our economy’s peculiarities? With a blunt knife, we cannot even slice a tomato!

The writer is a commentator on banking and finance