Is RBI acting as a Friend or a foe to Inflation?

Inflation is like fire as it can be beneficial for promoting growth of an economy but when it increases without bound, it takes the form of raging fire engulfing everything in its way and making livelihoods difficult.

India at present is facing both an increasing inflation and a precarious need to maintain the growth after the impact of the pandemic.

The probable reasons for high inflation in the domestic market are listed as follows

Ø The supply disruptions caused by the Covid-19 imposed restrictions across the trading channels which bid up the costs of inputs further fuming prices to exorbitant levels. Purchasing Manufacturers Index (PMI) for the quarter three of 2020-21 represents that around 57.8% of manufacturing firms and 52.2% of services firms faced increase cost pressures and raised the selling prices to around 37.33%.

Ø The recent pent-up demand after the successful containing of recent 3^rd wave and various liquidity measures undertaken by the governments all over the world to support the economic growth for promoting the demand for products. RBI in 2020 to tackle the pandemic created a on tap liquidity window of around 50,000 crore rupees for banks to promote lending. The government have extended the ECLGS scheme to all sectors along with a corpus of rupees 3 lakh crores to mitigate the losses suffered by companies.

Ø The recent invasion of Ukraine by Russia resulted in a massive surge in   energy and commodity prices all around the world which have aggravated the trade balance of a country which imports around 80% of its crude oil needs. The pass through of international oil prices to retail channels will impact the Oil Marketing Companies profits but in turn will raise the fuel retail inflation given that the current CPI index is around 8.73% and more retail fuel hikes are likely to be introduced in the coming months.

 

 

 As is evident from the above diagram that inflation rates had been on a rising spree which had further prompted the household expectation of inflation in coming three months to 9.7% as per the RBI survey which is higher than 8.2% in January 2021 mainly due to the facts that groceries and electronics are expected to get costlier by 10% due to a widening gap between input and selling costs. According to a report by Britannia Industries inflation in the current year is higher than the combined past six years due to oil, industrial fuel and packaging material prices.

As India imports around 60% of sunflower oil from Ukraine which is an indispensable part of food items in India and food being a major component of CPI along with the fact that higher crude oil prices at around $120 per barrel and the state government not allowing pass-through of such high international prices to the domestic prices mainly due to the state elections is adding too much volatility in Indian market. The composition of CPI as per MPIS records are

Hence, its pretty evident that increasing price levels are going to have deleterious effects on the consumer sentiments.

Then the lingering problem of the increase in both the fiscal and current account deficits is further creating an uncertain milieu in India. Firstly a 10% increase in oil prices could amplify the CAD by around $15 billion, hence impacting the trade balances. Secondly, to under take the massive investment program as mentioned in the budget 2022 the government needs to issue bonds or debt instruments but given the current high interest rates offered by the governments of the developed nations is adversely weighing on the Indian government bond markets. All of the above developments have resulted in India rupee becoming one of the worst Asian performing currencies which instigated the foreign investors to sell around $ 4.46 billion alone in month of January alone which can further impact Indian trade balance.

But all the above reasons are not enough to motivate the RBI to just let the interest rates rise in domestic markets by reducing the monetary policy to tackle the high inflation. Since RBI follows an multiple indicator approach to arrive at its target of growth, price stability and financial stability rather than targeting inflation alone. In its recent MPC meeting the RBI decided to keep the monetary policy accommodative to stimulate growth.

v If RBI increases the interest rates to tame inflation then borrowing will become expensive hindering the virtuous business cycle. Given that non-food credit grew to 8.32% year-on-year during January 2022 most of which was driven by loan growth from SME’s or retail segments rather than corporate sector, RBI is highly unlikely to interrupt this economic recovery as around 87% of self-employed in the urban space lost their jobs and the estimated loss to India aggregating to $26 billion. The ravages of this pandemic on the Indian economy is evident in the following graph,

 

Hence, RBI has to adhere its target of sustaining growth despite the raging inflation.

v According to RBI the drivers of inflation in India being the higher commodity prices and pent-up-demand is completely different from the divers in the developed nations such as consistent demand growth, and shortages of resources. Another reason for high inflation in the third quarter of FY22 was the base effect as from October 2021 the inflation momentum had been on a downward trajectory. The below diagram shows the inflation perceptions of the households which though high is still temporary as per the RBI monetary policy board.

 

                     

v A depreciating Rupee tends to increase the competitiveness of Indian exports and will allow our exporters to earn more Rupees from exported goods so the RBI may be willing to let the Indian currency depreciate further also it has a forex-reserves of $633 billion as of 7^th March 2022 which can be deployed to manage a gradual INR depreciation. India at current has the potential to fill in the void created in the EU nations trading agreements due to the disruptions from the war.

 

 

But all of this can be ephemeral if oil prices keep on rising and rupee depreciates by large amount and the government is not able to implement the trading agreements and rationalize the regulatory frameworks to attract EU nations to engage in trading pacts.

v RBI uses its Liquidity Adjustment Facility (LAF) to monitor the amount of liquidity in the market, within this framework the most popular are 14-day Variable Reverse Repo Rate (VRRR) and fixed repo rates. They are kind of instruments which are used to take out existing cash from the market through lending and borrowing among the RBI and commercial banks. In December 2021 RBI decided to hike the amount absorbed through VRRR from rupees 6 lakh crore to 14 lakh crore which has a negligible affect on the growth trajectory but can have an immediate impact on inflation. That why RBI shifted from fixed overnight repos to VRRRs which are more effective to achieve the twin targets of growth and price stability.

In macroeconomics there is Okun’s law which states that there is a negative relationship between unemployment and growth whereas Philip curve implies that there is a negative relation between inflation and unemployment thus further implying that there is positive relation between growth and inflation. But given the present scenario the growth is mostly based on panic driven consumption of essentials along with high liquidity and exchange rate risks which is the reason for the failure of positive relation between growth and inflation. But let us be optimistic and believe that the current scenario will not turn into taper tantrum of 2013 because of the optimum trade-off policies followed by RBI but we shouldn’t forget that

“Inflation is monetary phenomenon. It is made by or stopped by central bank”

-         Milton Freidman