Could inflation be the biggest surprise in 2020?

The concern about India’s ebbing growth is everywhere. Proponents of a big fiscal boost and sharp policy rate cuts still fret. The recent spike in headline CPI inflation bothers none. Reasons are obvious—RBI sees its one-year-ahead inflation forecast way below target (3.2%), and almost all analysts concur. There is merit in their position—so far, inflation has mostly raised food prices that have begun to correct, albeit slower than many expected. Those who focused too narrowly on onion prices alone were surprised to see its spread to other food items in recent months. But, that is not a big worry. What matters is core inflation—this depends mostly upon the output gap or demand, and is large in a deep, cyclical slowdown!

Logically, most expect headline inflation to converge towards core inflation. That is significantly different from India’s emerging inflation narratives in the days when inflation targeting (IT) was introduced. In those days, high core inflation would rise towards headline inflation, driven by high food prices and subsequent second-round effects through higher wages. Food inflation has ceased to be a threat since; the current episode is perceived to be temporary. Therefore, in hindsight, many question the wisdom of targeting headline inflation, but discussion on large output sacrifices has simply been brushed under the carpet!

The sublime, near-consensus views on inflation alongside narrowing current account deficit lead most to believe that macroeconomic stability is neither an immediate nor a medium-term concern. This led to advocacy of further fiscal expansion, and aggressive monetary easing to revive growth by some. But, the government and the monetary policy committee (MPC) seemed to have been cautious; the former limited deficit expansion to 50 bps in FY20 and FY21, within the amended FRBM bounds, and the latter watches carefully the evolving inflation dynamics while signalling that space exists for further rate cut.

Could inflation surprise on the upside in 2020? We attempt to flag several underlying risks from macroeconomic policy inconsistencies pursued so far, and which could potentially alter the outlook on inflation and jolt the complacency on macroeconomic stability. In the vigour to push growth, signs of incompatibility have gradually appeared, i.e., through adverse sovereign debt build up, off-budget borrowing to finance current expenditure, liquidity overhang, excessive capital inflows and reserves’ stock-up, high customs duties and market imperfections. Each of these factors is briefly examined below.

Fiscal dominance: The IT regime’s long-term success was contingent upon sustained fiscal prudence, anchored upon a defined and time-bound reduction of public debt to 60% of GDP (40% and 20% for the Centre and states, respectively). Yet, the central government has repeatedly altered the time path, pursuing an expansionary stance even while shifting large expenditures off-budget. There is opinion that states, too, could invoke FRBM’s escape clause to step-up spending given tax revenue shortfalls in FY20. What is worrying is that a hefty chunk of the additional expenditures, both on and off-budget, has been current spending. More disturbing is the drift of political economy towards newer income transfers and subsidy schemes, moving up the income ladder, across states.

With debt-GDP ratio expected to rise much above 71% in FY20, the consolidation path looks increasingly less credible. Historically, deficit expansion and accompanying debt build-up have been prelude to inflationary pressures, with demand being pushed above potential. It has been different this time—growth faltered precipitously at a time government was pushing up expenditure. Since there has been no ‘crowding-in’ of private investments, high current spending could eventually reflect in inflation. Further lower growth, on the other hand, would mean larger-than-expected deficit in tax revenues; if governments bridged this gap by raising user charges (electricity), prices (LPG, fertiliser), and possibly revisit GST rates, this could be an added tinderbox from an inflation perspective.

Liquidity overhang: With government borrowing taking up all financial savings, RBI has been compelled to inject ever more durable liquidity to lower costs. The recent long-term refinancing operation (LTRO) is another attempt in this direction. As result, base money (M0) and narrow money (M1) are growing fast—much above nominal GDP growth in FY19 and FY20—although broad money (M3) growth has remained relatively subdued from weak credit demand. Hence, the banks, unenthusiastic about project loans, are drenched in surplus while a large chunk of NBFCs remains liquidity-deprived due to high perceived risk. The fallout is that both private and public banks are chasing consumer loans, with RBI now extending some regulatory incentives. One has to wait and watch if this liquidity overhang in a narrow timeframe for credit expansion becomes a matchstick to light the tinder box.

Capital influx: Inflows have been consciously encouraged. Healthy FDI inflow is welcome, but the rationale for ECBs is suspect. With current account shrinking, RBI is buying most capital inflow to contain the rupee’s appreciation, or even manage its gradual drift. Reserves’ stocking has, thus, flushed more liquidity into the system, consistent with central bank’s overall strategy of durable liquidity infusion. With budget announcing to seek more portfolio capital, the liquidity build-up is likely to continue unabated, exacerbating inflation risks.

Such macroeconomic build-ups in different spaces are potentially destabilising. Further muddling comes from some structural policy reversals for domestic protection, i.e., raised custom duties, erection of other barriers. Trade restrictions, by design, remove competitive pressure, compromise on cost efficiency, and foster market imperfections, thereby germinating inflationary tendencies. When extended to final consumer goods, inflation risks are immediate and could spiral much faster.

Some imprudent domestic policies are playing out, too. The artificially low telecom tariffs were revised up, and RBI incorporated their effect, but the possibility of further, additional revisions is real. Then, the post-GST pricing of most consumer goods was under scrutiny the first two years; we have to wait and see if it is now time for redemption by such producers!

But then, what could have given confidence to the government and RBI? Possibly, the perceived large output gap, which is buttressed by dropping capacity utilisation rates; if aggregate demand is so low, it will find ways to absorb much of the liquidity without stoking inflation. But, things could go wrong—there was a recent period of high inflation with low growth in the last few years of UPA-II. If the economy is consistently failing to respond to monetary and fiscal stimuli, wisdom lies in revisiting estimated potential output.

Frankly, there is no clarity on how big this output gap is; or, alternatively, what India’s potential growth rate is. A statistical filter could place this above 6%, even 7%; a growth-accounting exercise may yield much lower potential output estimates, considering relatively slower growth in capital stock and lower labour participation rate. If the output gap is much smaller than most of these estimates, inflation risks could turn out to be real and surprise all in 2020. Much of the evidence would lie in how core inflation evolves in forthcoming months. One can only hope that January’s flicker in core inflation withers away!

The writer is New Delhi based macroeconomist. Views are personal.