High inflation and unanchored inflationary expectations

Unexpected inflation tends to hurt those whose money, received in terms of wages and interest payments, does not rise with inflation. Inflation can help those who owe money that can be paid back in less valuable, inflated rupees.

The Wholesale Price Index or WPI-based inflation surged to 14.55 per cent in March 2022, against a 13.11 per cent in February 2022. Consumer Price Index or CPI-based inflation stood at 6.95% in March 2022 compared to 6.07% in the preceding month. In WPI, more weightage is given to manufactured goods, while in CPI, more weightage is given to food items. WPI takes into account the change in price of goods only, while CPI takes into account the change in prices of both goods and services.

CPI or Retail Inflation is what concerns the general public. The retail inflation rate in India has been on the rise for five consecutive months, even before the Russia-Ukraine war. The inflation rate reached 6.1 per cent in January 2022 and 6.07 per cent in the following month, February. It stands at 6.95% in March 2022, the highest since October 2020. In March 2022, the inflation rate has decisively breached the Reserve Bank of India’s (RBI) upper tolerance limit of 6% for the third month in a row. The March retail inflation rate is also substantially higher than the RBI's revised inflation estimate of 5.7% for the financial year 2022-23.

In August 2016, Government of India legislated a new approach to managing inflation called flexible inflation targeting (FIT). The essence of FIT is that Government, in consultation with RBI, fixed an inflation target to guide the central bank’s monetary policy. The target right now is 4% retail inflation, with a band of two percentage points on either side to provide flexibility. It means, retail inflation in the range of 2 to 6% is acceptable.

Most countries have a range but usually set it closer to their inflation target. India and Turkey are the only two countries where the range is as high as 2 per cent in either direction. Moreover, unlike many other countries where if the inflation target is missed even for a month, it is considered a technical failure of the part of central bank, India permits the inflation target to be missed for nine consecutive months before qualifying it as a “failure”.

Retail inflation has hovered just over the RBI's target of 4 percent in only five months from November 2019 to March 2022. Hence, this high inflation can't be termed as transitory or temporary.

The six-member Monetary Policy Committee (MPC) headed by RBI Governor Shaktikanta Das kept the repo rate unchanged at 4 per cent, while the reverse repo rate was also kept unchanged at 3.35 per cent, after its April 6 - 8, 2022 meeting. The repo rate was unchanged at 4 per cent for the eleventh consecutive time, while maintaining an ‘accommodative stance’ ostensibly to spur growth rate of GDP. Though some cynics think RBI's low interest rates are more helpful for Government of India to borrow at low cost. The Government of India plans to borrow 15 trillion rupees in 2022-23, up from 10.5 trillion rupees in 2021-22.

Higher interest rates make money costlier and borrowing less appealing. That, in turn, slows down demand to catch up with supply, which has lagged badly throughout the pandemic, due to the slow-down of global supply chains. There’s also a psychological factor in play - inflation is thought to be something of a self-fulfilling prophecy. When the public thinks the cost of living will be higher, they adjust their behavior accordingly. Businesses increase the prices they charge to consumers and workers demand higher wages. The non-anchoring of inflationary expectations can potentially drive inflation even higher. A persistent high inflation is also negative for growth in the long run.

“By creating the erroneous perception that the MPC is no longer concerned about inflation and is focused exclusively on growth, the MPC may be inadvertently aggravating the risk that inflationary expectations will be disanchored,” Jayanth R Varma, an external member of the MPC said during the committee’s August 2021 meeting, according to minutes of the said MPC meeting.

Varma's comments about the RBI’s accommodative stance, make the case that the MPC must demonstrate its commitment to the inflation target with “tangible action”, and RBI must be perceived to be acting against inflation. Otherwise, high inflation and disanchored inflationary expectations feed into each other.
(V Venkateswara Rao is an alumnus of IIM, Ahmedabad and a retired corporate professional.)