With a new RBI Governor on his way (it has never been a ‘she’ so far), both bond and equity markets are going to be watching to see if he is an inflation hawk or a dove—needless to say, the two want totally different approaches to inflation-control—and the yardstick for measuring this will be the outgoing Raghuram Rajan. While the forecasts Rajan leaves behind—a CPI inflation of 5.1% for Q4FY17 and 4.2% for Q4FY18, going by the Monetary Policy Report in April—are seen by many as the Bible, it is important to keep in mind the inflation-target RBI and the finance ministry have agreed upon is 4% with a band of ±2% and RBI has a window of three consecutive quarters during which this can be breached, both on the upside and on the downside.
Chances are, therefore, that while the new RBI Governor will continue to swear by the agreed target—for the record, this newspaper is opposed to inflation-targetting—he will be more willing to relax it in order to stimulate growth. The bond markets will be remiss in seeing an inflation target of even 6% as a move away from the glory days of Raghuram Rajan.
It is important to keep in mind that today’s low inflation—including food inflation—is more the result of global deflation rather than the high interest rates that the bond markets cheered Rajan for. Between January 2014—that’s when data for the new series starts from—and April 2016, while CPI inflation was down from 8.6% to 5.4%, global wheat prices fell from $276.1 per tonne to $187.5, rice from $450 per tonne to $395, groundnut oil from $1,410 per tonne to $1,350 and crude oil from $107.4 a barrel to $42.3.
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So, if global commodity prices start going up again, even with higher rates of interest in India, the chances of inflation falling are slim since food inflation can once again reach double-digits. As Crisil chief economist DK Joshi tweeted in January 2014, “If food inflation stays at 10%, its average of the last 8 years, non-food inflation will need to come down to 2% for (the) 6% target; for 4%, it has to be -2%”. Since such a squeeze in industry/services prices will have its own impact in terms of a supply response, if overall inflation targets of even 6% are to be met, the government has to move to quickly remove the big supply constraints in the food sector—food has a 50% weight in the CPI—which include freeing up movement of food articles across the country, reducing supply-distorting procurement policies and subsidies,etc. While bond markets need to keep these supply-side bottlenecks in mind, the government has to realise RBI cannot meet the inflation target unless it plays its own role—not meeting the inflation-target is more the government’s failure than the central bank’s.