Atypical dynamics of high inflation and weakening demand, with other growth drivers fizzling out, could close the monetary space available TO the MPC
RBI sent markets into a shock by deciding not to cut the policy rate last week. Overturning consensus expectations of further easing, the central bank slashed the FY20 growth forecast by 110 basis points to 5%, which was commonly anticipated. On the other side, the central bank revised up its inflation forecast for H2FY20 by 1-1.6 percentage points to 4.7-5.1%; H1FY21 inflation forecast was scaled up 20-40 basis points to 3.8-4%. The unanimous decision to pause while staying accommodative was even more surprising in light of the assessment that the food price push to headline inflation was transitory—at least one or two dovish members could have been expected to press seeing through the temporary shock, given the steep downgrade of growth.
At the post-policy media interaction, the RBI Governor was asked precisely why, if the food price spike was short-lived, the MPC did not chose to override and ease more when growth had slipped so low. Acknowledging such a case, the Governor alluded to core inflation that was currently expected to remain under 4%, but on whose evolution the MPC wanted more clarity with regard to certain decisions, like telecom tariff and other things that may play out, including any countercyclical fiscal measures in the forthcoming budget. The Governor also pointed out the primary objective of an inflation targeting central bank is price stability, while due weightage has been assigned to growth. Executive Director and MPC member Dr MD Patra elaborated some more on this, flagging additions to core inflation from price increases in some of its components such as transportation, health, and education, besides the possible telecom tariff impact.
From a macro diagnostic point of view, however, the central bank’s bigger worries may be potential fiscal slippages, and the persistent overhang of surplus liquidity in the system, a recipe for triggering inflation. The sharp rise in bond yields following the post-policy announcement sent out the unambiguous signal.
Inflationary expectations overlooked
Curiously, the central bank did not sufficiently press upon the crucial link of households’ inflation expectations, which adapt to food prices in India and are the bridge of transmission to core inflation. In turn, core inflation can potentially spillover into generalised inflation if second-round effects take hold. The written MPC statement detailed that households’ inflation expectation rose 120 basis points over the three-month ahead horizon while the increase was a hefty 180 basis points over the one-year ahead horizon in November. This rise occurred on top of a pick-up two months earlier, in September, when inflation expectations had increased 40 and 20 basis points respectively, over the July round. In the four months to November, three-month ahead inflation expectations of households zoomed from 7.6% to 9.2%, and those over the one-year ahead horizon jumped from 7.9% to 9.9%!
This, perhaps, is the key reason for the MPC’s unanimous decision to pause, its preference to watch how core inflation unfolds ahead, and to be sure of the inflation forecasts. However, an open apprehension of the possibility of such a scenario in an environment of sliding demand would be an unexplainable oddity, which could trigger a further slide in negative sentiments.
Hunt for revenues could be the trigger
While the central bank and the market are worried about large fiscal slippages given anaemic revenue collections until now, the trigger could come from raising tax rates. Press reports suggest the GST Council contemplates significant rate hikes across slabs. The telecom tariff decision is but one example RBI spoke of. There could be others. Most arise from a frantic revenue hunt by the government, which faces a mounting deficit as collected taxes fall. Telecom firms revised tax liabilities, after a court ruling prompted their tariff hike, and other affected firms could respond similarly, e.g., GAIL may have no choice but to raise gas prices. Sliding GST collections have pressed the government to review tax and compensation cess rates, inclusion of exempt items, etc, to augment revenues. One needs to watch out if the states follow suit and revisit VAT rates, e.g., on fuels, as they, too, face revenue pressures and have been compressing capital expenditures. Some signs of revenue triggers to prices are visible amongst private firms as well; for example, auto manufacturers have announced hikes in January 2020 even though pricing power is absent amidst weakening demand, and production cuts continue in some pockets.
Typically, tax increases are one-off, and not considered inflationary because of a one-time increase in costs. Central banks look through these and RBI has done the same in the past. But, in an environment of rising inflation expectations, the fear of a price spiral build-up is perhaps what RBI would carefully watch for. Then, although food inflation may come off as expected, supply management could fail to contain anticipated and/or unanticipated shocks as happened recently. There is also the enormous liquidity overhang on the monetary side, a potential ignition to the cocktail of latent cost-tax pressures in a revenue-constrained economy. Further monetary easing in such uncertain macroeconomic settings could also create another round of credibility issues for RBI, which grappled with overpredictions of inflation one year ago, and, in the current year, has been caught out with overpredicted growth. The Governor’s emphasis on gaining clarity on the inflation outlook could be driven by these apprehensions and the reason for a pause.
The return of inflation fears couldn’t have come at a worse time. Growth has steeply declined for six successive quarters as the economy has been passing through a phase of sharp demand contraction. Raising taxes at such a juncture could further compress demand and hurt consumer sentiment. Ironically, these taxes, if raised beyond a critical level, could push up core inflation, resulting in stagflation. An atypical dynamics of high inflation and progressive weakening of demand is a macroeconomic challenge, especially when other growth drivers, viz. government spending, private investment, and net exports have all fizzled out, leaving alone monetary policy. If such a dynamics does come about, it could close the remaining monetary space that the MPC assured of in the policy review.
New Delhi based macroeconomist
Views are personal