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RBI needs to remain vigilant on inflation

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Now that finance minister Nirmala Sitharaman has presented the Union Budget 2023-24, which is neither populist nor expansionary, all eyes are on the Reserve Bank of India (RBI) as it gets ready to announce the monetary policy on February 8. Inflation in India is on a downward trajectory from the high levels in the first half of 2022. Yet RBI must be cautious about taking its foot off the pedal as far as taming inflation is concerned.

The apex bank has been following an inflation-targeting framework for conducting monetary policy since 2016. The framework mandates RBI to achieve a consumer price index (CPI) inflation target of 4%. For most of the calendar year 2022, CPI inflation averaged 6.9% and the inflation target was not achieved for 10 consecutive months. From October onwards, inflation has been declining. As a result, the average CPI inflation in November and December dipped to 5.8%. This means that inflation is now back within RBI’s tolerance band. This is a positive development not only because inflation seems to be moving towards the 4% target but also because high inflation disrupts macroeconomic stability.

However, this recent decline does not mean that inflation has ceased to be a problem. There are four main reasons why risks to inflation persist.

First, while headline inflation has come down, core inflation (non-food, non-fuel) has been stubborn. For example, in December 2022, core inflation was 6.2%, the same as the full-year average. In fact, core inflation has been sticky around 6% for almost three years now — from April 2020 to December 2022. Persistent core inflation implies that price pressures have become embedded in the system.

There may have been three phases that can help explain the core inflation dynamics. In the first phase, once the coronavirus pandemic hit India and widespread mobility restrictions were introduced, supply chain bottlenecks became intense, services were shut, and goods and labour were hard to come by. This started putting upward pressure on core inflation. In the second phase, as the Russia-Ukraine war broke out in February 2022, input prices skyrocketed, and manufacturing firms began passing on the higher costs to consumers. We can then think of a third phase, when commodity prices began easing, thereby softening the input price pressures on producers, but services began actively normalising. For two years, the services sector could not adjust wages and prices. Now that the economy has opened up, they are paying higher wages to workers to compensate them for the price increases that occurred while they were away and are adjusting prices accordingly. This is keeping the core inflation high.

Apart from core inflation, cereal prices have been steadily going up — and this is the second reason. Between May and December 2022, cereal inflation more than doubled. Within cereals, inflation in wheat went up drastically from 9% in May to 22% in December, while inflation in rice increased from 3% to 10% during the same period. Food accounts for 46% of the overall CPI basket, and within the broader food group, non-perishables such as cereals and spices have almost a 37% weight. This means that these items determine the underlying trend in CPI food inflation. Non-perishables inflation increased from 5% in November to more than 8% in December 2022, reaching the highest level in more than two years. Much of the decline in overall CPI inflation in November and December was driven by perishables such as vegetables, which registered a steep fall in prices. Excluding vegetables, CPI inflation increased to 7.2%.

Third, while inflation in the developed world has also been coming down, it is still high. For example, inflation in the United States was 6.5% in December, while inflation in the European Union and the United Kingdom remains more than 9%. India continues to import this high inflation through the international trade channel in goods and services.

Finally, as China opens up after three years of Covid-19-related restrictions, the recovery of its economy from a growth slump is likely to exert upward pressure on commodity prices, given that China accounts for a large share of global commodity demand. This may fuel inflationary pressures in India, which imports commodities.

Therefore, what should policymakers do?

The government seems to have done its bit. With nine assembly elections scheduled between now and January 2024, and the country going into general elections in 2024, the apprehension was that the government would announce a slew of populist measures in the Union Budget presented on February 1. This would have disrupted fiscal consolidation and aggravated inflation. However, the government has not given in to populist demand pressures. Instead, it has announced a steep increase in capital expenditure, which is undoubtedly a demand stimulus, but a lot will depend on implementation.

Now the ball is in RBI’s court. While the central bank has been tightening monetary policy from May 2022 onwards, increasing the repo rate to 6.25%, it now needs to indicate when it expects inflation to reach the target level of 4% and what its plan of action is to bring this about, mainly to break the persistence of core inflation. Low and stable inflation generates macroeconomic stability and creates a favourable environment for growth. On the other hand, high and sustained inflation hurts the poorer sections the most, and can have a detrimental political effect in an election year.

Rajeswari Sengupta is an associate professor of economics, Indira Gandhi Institute of Development Research, MumbaiThe views expressed are personal

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