In its last monetary policy in February, the Reserve Bank of India (RBI) had projected retail inflation to be 4.5 per cent for the next year. The ongoing geopolitical tensions and accompanying supply side bottlenecks would likely disrupt the inflation calculations around the world and in India.
At the same time, as the economy recovers from the pandemic, and government policy pushes for jobs and public investment in infrastructure rises, demand is expected to rise. The RBI will have to revisit its inflation projections and adjust its policy stance in light of the elevated inflation risks.
The disruptions in prices are mainly being caused by supply side issues on the one hand, and post-Covid demand increase on the other. The core question facing central banks today is how to respond to the elevated inflation. One way to go would be to say that we will wait for the supply side issues to resolve and then take a stance on monetary policy. However, this is fraught with risks as it may raise inflationary expectations in the meantime. These then tend to have persistent and long-term impact on inflation. A normalisation of monetary policy was expected post Covid in any case, and that would have meant raising rates over the course of this year. RBI now has to signal how it intends to deal with the present inflation surge.
A lack of a clear signal will have consequences not only for domestic inflationary expectations, but also for the currency. If inflation in India is to remain high and interest rates low, expectations of a weakening currency may become more widespread. Along with the elevated oil import bill, expectations of rupee depreciation could lead to capital outflows. While the RBI may use its foreign exchange reserves to intervene in the short run to reduce volatility, the combination of higher inflation, low interest rates and selling reserves is not a sustainable path to rupee stability.
Higher retail inflation
The retail inflation based on Consumer Price Index (CPI) rose to 6.07 per cent in February, breaching the upper tolerance band for the second month in a row. The rise in retail inflation was broad-based, driven by the rise in prices of food products including cereals, eggs, meat, milk products and vegetables, as well as paan and tobacco, clothes and fuel. The wholesale price-based inflation spiked to 13.11 per cent in February, marking the 11th consecutive month of double-digit inflation. A sustained and elevated Wholesale Price Index (WPI) inflation could be seen as a precursor to higher consumer prices as producers may start passing on the burden of higher costs to consumers.
Global inflationary headwinds
Global crude oil and commodity prices have risen significantly since the onset of the Russian invasion of Ukraine and consequent sanctions. Although oil prices fell below $100 per barrel as talks triggered hopes of easing global tensions, they are likely to remain elevated as sanctions are unlikely to go anytime soon.
Global food prices measured by the Food and Agriculture Organization’s (FAO) Food Price Index (FFP) registered a record growth of 20.7 per cent in February. The index tracks monthly changes in the international prices of commonly traded food commodities. The spike in the FFP was primarily driven by a sharp increase in vegetable oil prices. While these have remained elevated due to sustained global import demand, fresh concerns around lower exports of sunflower oil due to disruptions in the Black Sea region further accentuated the price surge. If the war continues, the price of sunflower oil, palm oil and soybean oil could rise further.
Supply shortages on account of the ongoing geo-political conflict has led to a steep surge in metal prices. In an unprecedented move, the London Metal Exchange had to suspend nickel trading as prices doubled on concerns of supply disruptions from Russia due to Western sanctions. Aluminium, copper, zinc and lead prices have also spiked due to the ongoing geopolitical crisis.
Outlook for domestic inflation
Ninety per cent of India’s total sunflower oil imports come from Russia and Ukraine. The ongoing war has led to choking of supplies of sunflower oil and has increased the demand for other oils such as palm oil and soybean oil. Elevated vegetable oil prices are likely to cause an uptick in domestic food inflation. Increase in the price of fertilisers could also pose an upside risk to food inflation despite a normal monsoon.
With the prices of metals used as raw materials in consumer durables and appliances rising, several manufacturers have already hiked prices and several others have indicated that they will start raising prices in the coming weeks. The transmission of input costs would show up as elevated core inflation in the coming months.
Fuel companies till now have not passed on the increase in prices to consumers. After an excise tax cut by the government on 3 November last year, domestic oil pump prices have not been revised. At that time, the crude oil price was around US$ 85 per barrel. While the global crude oil price has retreated from the high of US$ 139 per barrel, it is still close to US$ 100 per barrel.
Even without a pass through of elevated crude oil prices, the retail inflation has surpassed the upper threshold of 6 per cent. It is possible that the government could absorb a part of the price increase but the possibility of absorbing the full rise in prices seems unlikely as its finances will be hit. If some part of the increase goes to consumers, it will push up inflation. RBI’s estimates suggest that if crude oil prices rise 10 per cent above the baseline (assumed as $75 per barrel), domestic inflation could be higher by 30 basis points. Currently oil prices are hovering 35-40 per cent above the baseline. The hit to inflation would be much higher.
Implications for monetary policy
The RBI has been supporting economic growth by reducing rates and maintaining a dovish stance. In its last monetary policy, the RBI chose to maintain a status quo on rates and an accommodative stance to support growth even when inflation was above the 6 per cent tolerance limit. The RBI was seen as falling behind the curve in managing inflationary expectations at a time when other countries’ central banks have fast-tracked monetary policy normalisation amid surging inflation levels.
The US Federal Reserve, in its latest policy, raised the interest rate by a quarter percentage point to address spiralling inflation. The interest hike came in after the US CPI accelerated to a four decade-high of 7.9 per cent in February. The Federal Reserve signalled more interest rate hikes by year end.
The RBI needs to start making adjustments in its projections and operations and lay down a clear path of normalising its monetary policy. A delay in formalising the normalisation of monetary policy to support the government borrowing can further heighten inflation risks and affect the credibility of the inflation targeting regime.
Ila Patnaik is an economist and a professor at National Institute of Public Finance and Policy.
Radhika Pandey is a consultant at NIPFP.
Views are personal.