By Invitation. Flexible inflation targeting can be a challenge

There is a regime shift in the conduct of monetary policy in India. Policy makers are adopting a flexible inflation targeting regime and the Monetary Policy Committee (MPC) has to maintain CPI within the 4 +/- 2 per cent band. The framework is expected to anchor medium-term inflation expectations around the CPI midpoint and would contribute to enhanced policy credibility. But, the shift is bound to pose implementation challenges.

Consumer price inflation, as measured by the new CPI series, has averaged 4.9 per cent in FY-16 and is expected to be at 5.2 per cent in FY17, with the latest reading at 6.07 per cent Y-o-Y. Transitioning to the mid-point of the band over the medium term, which would align inflation in India more closely with most other emerging market peers, would require significant supply-side responses as well as a credible fiscal policy that complements monetary policy.

However, the current framework also recognises the compulsions of short-term supply/weather-related shocks that can potentially keep headline inflation elevated. The upper range of 2 per cent above the mid-point as well as the time lag of three quarters for a breach of the range that formally qualifies as a failure to meet the target, are expected to provide sufficient elbow room to meet unanticipated disruptions.

There are still some challenges expected in the pursuit of a durably lower CPI towards the midpoint. One, there are supply-side rigidities to contend with. While weather-related factors contribute to food price volatility, inefficient containing of services sector inflation has hobbled agriculture and led to higher food price inflation and lower farmer incomes.

The success of recent initiatives such as enhanced investments in irrigation and logistics, crop insurance, National Agri E market and APMC reforms are equally important in weather-proofing agricultural output as well as keeping food prices contained. With food articles accounting for about 46 per cent of the CPI basket, the importance of keeping food price inflation moderate cannot be overstated.

Two, Government fiscal policy measures which complement the monetary policy stance are important in anchoring inflation. Large-scale increases in minimum support prices, without matching productivity gains, as well as income transfer schemes and broad-based subsidies have, in the past, contributed to keeping inflation persistently elevated. The fiscal policy stance can in future impinge on the RBI’s ability to meet the 4 per cent inflation target.

Three, containing services sector inflation. This factor, proxied by CPI miscellaneous, has averaged about 5.8 per cent since the inception of the index in January 2012. Sub-indices such as health and education have averaged around 6.2 per cent and 7.6 per cent respectively and have remained sticky. With services increasingly becoming a larger share of the consumption basket and the potential impact from higher service taxes, the inflation in this sector will be a key variable likely to influence CPI.

The possible impact of government fiscal policy on medium-term CPI and inflation expectations arising out of the Pay Commission awards and GST implementation, must also be factored in. The Central Pay Commission awards and the expected state-level pay revisions could have the near-term impact of enhanced consumption demand. While statistical near-term impact on CPI due to HRA revisions can be easily evaluated, the second order impact on demand — especially for services — needs to be thought through.

A GST rate that is in principle a ‘Revenue Neutral Rate’ is theoretically expected to not impact prices at an aggregate level. However, with service tax rates expected to move higher and given the increasingly service sector-oriented economy and the relative stickiness in services inflation, the first order impact of GST can be potentially inflationary at the margin.

The government has also constituted a committee to review the Fiscal Responsibility and Budget Management (FRBM) framework and to explore the viability of a fiscal deficit range that can accommodate changes in business cycles. Decisions pertaining to the framework of fiscal consolidation as well as time frame can potentially impact the conduct of monetary policy, especially if fiscal spending were to be prioritised in the short term to give an impetus to growth. This can potentially open up conflicts with the targeted inflation numbers as per the MPC’s mandate.

Overall, the attainment of 4 per cent medium term target is challenging . As cyclical disinflationary impulses have largely played out, the near-term focus should rest on conditioning expectations of CPI closer to 5 per cent since 4 per cent seems aspirational currently. At the same time, the MPC framework could face implementation challenges arising from large-scale capital flows, any potential threats to financial stability as well as periods when growth/inflation mix remains more challenging.

In such cases, the MPC would face the challenge of maintaining credibility around the inflation anchor if it flexibly deviates from the upper band.

The writer is Head - Fixed Income, SBI Mutual Fund