That there is now a reduced degree of confidence over demand-side inflation pressures remaining quiescent is highly debatable
Federal Reserve chairman Jerome Powell’s communication was calm and precise at the Jackson Hole meeting. As The Economist described it, “He speaks to ordinary Americans rather than economists.” Powell was emphatic, while being careful to assert that inflation was transitory and would decline to the 2% target, that the Federal Open Market Committee (FOMC) would continue to support the economy until it achieved a full recovery. Many critics believe this may be a high-risk strategy, but Powell’s been able to convince the bond market that running an ultra-loose monetary policy posed no threat to long-term inflation. As result, the US 10-year benchmark yield recently declined to 1.30% from a peak 1.75% in April 2021.
Back home, RBI Governor Shaktikanta Das has also been trying to communicate a similar message—that inflation was transitory, would decline to its 4% target in the medium-term, and the Monetary Policy Committee (MPC) would continue to support the economy to revive and sustain growth on a durable basis. But there is a stark difference: he has had to let the 10-year benchmark yield rise by 25 basis points, failed to convince the market that resumption of variable rate reverse repo (VRRR) auction was not a liquidity tightening measure, and been countered within the MPC by professor Jayanth Varma with probing questions about credibility.
In the MPC meeting minutes released on August 20, Varma expressed apprehensions over inflationary pressures showing signs of greater persistence, inflationary expectations getting widely entrenched, while demand side pressure was no more benign to be ignored. These, he said, had tilted the balance of risks against staying with the accommodative policy for longer. Because Covid-19 had turned more endemic, its impact more localised and limited to a few sectors, monetary policy would be least effective; therefore, it would be prudent to signal normalisation by gradually raising the reverse repo rate to narrow the policy corridor. In a subsequent interview (Business Standard, August 23), he succinctly explained why current conditions required the operational policy rate be restored closer to repo rate (4%) to ensure long-term macroeconomic certainty; he emphasised that losing credibility could jeopardise RBI’s resolve to fight against inflation and courted risks of exposing the economy to disruptive rate hikes at later dates.
Has inflation been showing signs of greater persistence? Or, if average inflation has been close to 6.2% over a period of 20 months, beginning December 2019, then how do you characterise it as temporary? The average, as we know, was not the whole truth; rather, it suppressed the underlying trend. Inflation is characterised as temporary if any supply-side issues trigger a sudden spurt, which self-corrects once sorted out. Unfortunately, over the past 20 months, whenever inflation began to dissipate, another shock struck: the first phase of high inflation, triggered by unseasonal rains in October 2019, was beginning to decelerate in March 2020 when a national lockdown was announced; then again, when inflation declined sharply beginning November 2020 after persisting for a six-month interval, the second phase of lockdowns arrived. If anything, inflation has again begun to decelerate after only two months with July’s outturn below the expected consensus. If crashing prices of tomato is any lead indicator, then inflation may surprise on the downside, relative to RBI’s one-year ahead projection, given the recent depressing private consumption estimates released by the NSO!
Some may argue that headline inflation may have worn off after each shoot-up but the underlying core inflation has persisted. That should not have surprised the market, let alone any MPC member. Most contact-based services have been impacted during COVID, while the world over, demand has been skewed towards tradable goods. This distortion would straighten once activities normalise. Besides, a sizeable part of the increases in tradable goods are cost-push in nature, reflecting the global rally in oil and commodity prices; equally, another significant part is policy induced, i.e., high fuel product taxes, custom duty increases, domestic industry protection from cheap Chinese imports, and environment-related technology shift. These have resulted in price/level adjustments, but unlikely to persist in the absence of any momentum in demand.
However, the fear of entrenching inflationary expectations could be a genuine concern since there are some indications that Indian consumers generally react to the level effect, especially for food items. Inflation targeting frameworks try to retain policy credibility by responding proactively to offset any possibility of inflation getting generalised with second-round impacts.
Should that be reason enough for RBI to raise the reverse repo rate? Not quite! The operational framework for the regime also requires maintenance of a delicate balance between the inflation gap and the output gap. If the latter is negative and visibly large, the MPC must exercise caution; look for evidences if wage rates are lighting up. It is no secret that workers who walked bare-feet to their villages in April-May 2020 are still seeking jobs under MGNREGA.
Varma’s point that there is now a reduced degree of confidence that demand-side inflation pressures would remain quiescent is highly debatable. Unless one assumes that Covid-19 has significantly dented India’s potential GDP, the evidence for the output gap closing faster is very weak. The recent trend in private final consumption expenditure and bank credit offtake are stark reminders that optimism should not run ahead of time. When RBI widened the policy corridor on March 27, 2020, it did this to induce banks to lend than passively park funds with the central bank. We don’t know if that worked, but any reversal will likely hurt investor sentiment. It could also risk letting the market take the lead, making it difficult to retain the policy rate at 4% as the market has already factored in one or two rate hikes in FY23.
India’s growth recovery is precariously poised. The size of the economy is still lower than in FY20, which itself was the outcome of its weakest growth in over a decade. Optimistic soundbites are unlikely to alter the scenario overnight. Given that space for fiscal support is increasingly getting emptied, sustenance from an accommodative monetary policy would be critical. In the tight battle between opposing psychologies—credibility versus fragility—monetary policy should continue to support growth until it is on a firm footing. As Powell warned, if inflation turns out be temporary, the main policy effects are likely to arrive after the need has passed and possibly damage the real economy. The risk is worth taking.
The author is New Delhi-based economist