Inflation Taming. Need Both Monetary Intervention, Fiscal Action
Inflation is galloping. Food and vegetable prices are up 12 per cent and climbing, clothing and footwear prices are up by nine per cent. Most poor are in distress. The rich too are beginning to ‘notice’ the rising prices. The political system is equally concerned and can no longer remain indifferent and aloof.
Inflation is an outcome of several ‘knowns’, but equally some ‘unknowns’. The collinearity between events that trigger inflation and outcomes as a result of those events is often dodgy, mostly indeterminate. The economic phase and cycle, and the accompanying economic activities play a far bigger role than imagined or acknowledged.
A ‘little’ inflation acceptable, beneficial; and not detrimental to growth
Central bankers must embrace the idea that for a growth economy like ours a ‘little more than a little’ inflation may not be a bad thing. The pandemic induced lockdown halted economic activities. It disrupted the supply chain, triggered higher input cost that translated into soaring consumer prices. India will import inflation due to the rising cost of raw materials. The Russia-Ukraine conflict has escalated the pain.
While inflation has been supply-led, one cannot ignore the role of demand.
Lockdown was particularly harsh on the smaller firms that lubricate the economic wheel, create jobs and drive consumption. The Indian economy has a rapid (fuelled by fiscal and monetary stimulus), but equally lumpy and craggy recovery. The nature of recovery has adversely influenced key economic drivers.
Inflation is transitory. Will rise, before it ebbs. Taming will need some doing
It will need both the monetary ‘intervention’ to cool the heating economy, as well as fiscal measures to ease the supply constraint and reduce cost.
About 300 items across, eight ‘major’ categories constitute the consumer price index (CPI). They include food, housing, household operations, clothing, transportation, health and personal care, education etc. They are assigned proportionate weights. Data is collated from over a thousand rural points, across 300 urban towns. The methodology is robust enough.
However, CPI is a ‘convenient’, not an accurate reflection of consumer spending, nor an explicit estimate of the cost of living. As an example, weightage of food in the CPI is close to 50 per cent. Indian households don’t nearly spend that much on food. They spend more on services such as education, healthcare, and transportation.
Hyperinflation, besides putting upward pressure on interest rates, imposes downward pressure on the rupee. Rising input costs as a result of inflation have a spiralling effect, and adversely affect economic efficiency. It particularly hurts the fragile MSMEs who have neither the moat to ‘pass on’ the price increase, nor the negotiating power to reduce input cost. There are also several impacts that are indirect and intangible. Inflation gashes investment sentiments, increases inequality. If not tamed, it may derail the growth momentum and impede growth.
Inflation by nature is porous. Feeds on itself
Inflation is globalised; has engulfed over 80 per cent of the global economy. Inflationary pressure, particularly in the USA, may create a more pronounced domino effect across most emerging economies. This will weigh heavily on the minds of the policymakers, even though the linearity and the impact of inflation is getting less pronounced. India will not catch cold if the USA sneezes.
The monetary policy plays a key role and can theoretically alter the course of the economy (steering the economy from the perils of rising inflation). However, monetary institution must make a judicious decision, primarily based on whether economic growth is above the ‘long-run’ trend rate, and whether this growth is caused by aggregate demand increasing faster than productive capacity. Raising interest rates may seem like an obvious solution but not the only one. Raising interest rates may solve one problem, trigger several others, especially for an economy that is facing growth pangs. They need to honestly evaluate their ability to influence the economy.
Monetary doers must examine both the nature of the relationship between inflation and growth, and the direction of causality. History tells us that all possible combinations have occurred: development with and without inflation, no inflation with and without development. The European economy ‘suffers’ eight per cent inflation and yet has a zero rate of interest. This narrative must evolve our thinking.
Monitory mandarins must row yet keep the water still. Avoid disruption
Raising interest brings in other macro challenges. Some get entrenched. And there is a delicate balance. The economic facing institutions must play a balancing act. They must guide the economy along the safest route and navigate it through the fastest growth pathway. This inflation is largely because of supply-side issues and is not demand-led, and needs more than the monetary healing (raising interest rates and tightening liquidity).
They will need to apply small, opposing pressures and release a little simultaneously and several times.
They must lean on the CPI data but importantly anticipate what is around the corner, focus on trends to be ahead of the curve. They must monitor, and manoeuvre.
Despite the bravado, economic growth is patchy, still not durable. The RBI should be persuaded to hold interest rates, to support growth and nurture the economy. However, something has to give. Resorting to fiscal measures i.e. reducing import duty on intermediaries. Fuel prices have a substantial and a direct impact on the household budget across several pricing points. It has the potential to create a pronounced and cascading inflationary effect. The weighted contribution of fuel (direct and indirect) is around 1.9 per cent in the overall inflation numbers. For every 10 per cent increase in fuel cost there is a 0.5 per cent increase in CPI numbers.
A substantial portion of taxes that consumers pay ‘goes’ to state governments. They need to come on board.
Devil’s Alternative
Inflation, even if it’s temporary, needs taming and the finance ministry uses the abundant fiscal space to supplement the effort of the RBI.
Hyperinflationary pressure spooks governments. Most governments in India have been voted out of power in spite of inclusive and healthy growth. Macro indicators are very noisy, but we should not sacrifice the much-needed growth for a temporary (solvable) pain. The economic actors should prioritise economic growth ahead of taming inflation. They need to watch the ‘trends, and not the numbers’.
The political leadership must think long-term, diligently focus on jobs and growth, which are long-term multipliers.
