Point of View. Tug-of-war: Inflation vs disinflation

Even after 150 basis points of interest rate cuts from the RBI, expectations of further easing continue. To some extent, the central bank itself is helping these expectations.  Its forward dovish guidance is qualified partly by the evolution of near-term events, including the monsoon. This leads the market to also incorporate such events into its policy expectations. Indeed, it is even possible that the central bank delivers depending on the outcome of monsoon.

Nevertheless, the idea seems strange from the following standpoint: It is well accepted that rate changes affect real economic activity and hence inflation with a lag of 2-3 quarters at least. Hence, rate cut undertaken on the outcome of the current monsoon will likely start to affect activity and inflation dynamics only closer to the next monsoon. And if that one turns out to be bad, monetary policy would concurrently be providing net new incremental stimulus just as prices started to creep up.

The larger point here has to do with differentiating the ‘cyclical’ from the ‘structural’. Given that monetary policy is a slow moving tool, there are decided risks in responding excessively to the cyclical including, good or bad monsoon. Rather, cyclical windfalls could be used to create buffers on policy targets. In the case of India, we have recently exited a long period of high CPI inflation.

This needs to sustain for inflationary expectations to sustainably fall. Only then can we enter a long period of lower nominal interest rates without compromising savings-investments balance.  

One cannot understate the important policy steps that have aided the substantial fall in our CPI. These include judicious setting of minimum support prices, proactive offloading of cereal stocks in the secondary market, and progressive fiscal consolidation.

However, this period has also coincided with global commodity prices collapsing. Also, owing to back-to-back rainfall deficiency, rural wages have fallen over this period. This has severely curtailed affordability and generated disinflation in many consumption items. It is likely these forces of cyclical disinflation will not be as evident going ahead. Commodities have risen handsomely over the past few months.

Even if some of these gains are to be reversed, it is unlikely that we will see further incremental disinflation from this quarter. Also, rural wages cannot sustain at their current stress levels from a welfare standpoint. They will go up, helped both by better rains as well as government policies. Thus, it is quite clear that the next gains in disinflation need to come from harder structural measures, including irrigation, storage and better market access.

To be fair, work is in progress in these areas. But it will take time to solve these long-standing structural issues. Meanwhile, monetary policy needs to ensure that some buffers are kept intact so that turns in cyclical tailwinds don’t necessitate an adverse change in policy rates.

 The task of managing inflationary expectations is further complicated by extreme volatility in certain food items. While volatility in cereal prices has been effectively killed owing to large buffer stocks and their efficient release, other items, particularly vegetables, still tend to be extremely volatile.  

The RBI has an effective CPI target band of 2-6 per cent. Despite two years of disinflationary tailwinds, inflation is finding difficulty in breaking below 5 per cent.

Even if a good monsoon helps via food price fall, it is unlikely to be sustainable. Such episodes of disinflation could be used to improve our buffer on the 2-6 per cent CPI range to protect against lack of disinflationary tailwinds. It is up to the RBI to re-form future policy rate expectations, including the government, so that they are better aligned to a credible medium-term CPI targeting framework

The author is Head – Fixed Income, IDFC Mutual Fund. Views expressed are personal