Growth and inflation: Hard choices vs easy trade-offs

Consider one Monetary Policy Committee’s (MPC) member’s statement as recorded in the minutes of the June 2023 meeting. Jayant Varma, an external member, noted the following: “Monetary policy is now dangerously close to levels at which it can inflict significant damage to the economy.” With every successive meeting, he added, the current policy stance “is becoming more and more disconnected from reality”.

In his monetary policy statement, the governor projected the inflation for the year at 5.4%; the numbers for July must have been a rude shock. The central bank’s estimated inflation for the second quarter – July to September – is 6.2%. After July, that seems rather unlikely.

Almost every other central bank of the major economies is worried, if for different reasons. Despite a decline in inflation, Fed chair Jerome Powell raised the Fed funds rate – the policy rate in the US that is the equivalent of the RBI’s repo rate – again. The latest inflation number for July showed an increase, but overall, inflation is slowing.

In Japan, after decades of almost zero policy interest rates, the Bank of Japan’s Governor made changes to its yield curve control (YCC) policy, in essence, tightening it. In Europe and the UK, inflation remains a serious concern among central banks.

True, monetary policies among the major economies are no longer as coordinated as they used to be; each country is choosing its own path. India began ‘de-coupling’ earlier than the rest. This also suggests that the dynamics driving inflation are changing. The mix may seem the same, but the weight of global versus domestic factors is shifting towards the latter, leading to some unanticipated shocks, like tomato prices.

Let’s talk about inflation

An article on the state of the economy in the RBI’s July 2023 bulletin has some interesting insights on the behaviour of tomato prices spanning over 13 years, from 2010 to mid-2023. Researchers found the following: prices stayed below ₹20 for about 10 fortnights (or roughly 5 months), between ₹20 and ₹40 for about four-five fortnights (two and a half months) and above ₹40 for between two and three fortnights (a month-and-a-half).

But here is what most observers may have missed: in almost ten out of the 13 years – and during the last five in particular – peak prices moved higher every successive year, reaching over ₹200 in some markets this year. The lows remained steady around ₹20. Inflation in tomato prices has been building up for a long time; this year, they stayed above ₹40 for much longer than average, too.

Food and energy prices are volatile and add significantly to headline inflation. That’s why the RBI provides two sets of figures to enable better analysis and thus better policy: headline inflation which includes all products and is not adjusted for volatility and seasonality, and core inflation which excludes food and energy prices in the household consumption basket. Food comprises about 43% of the consumption basket in India.

Core inflation declined but only marginally to 5.1%, and commodity prices, except oil, moderate further, core inflation will be stable around 5%. The fear is whether food price inflation will spill over into other parts of the consumption basket, driving up even core inflation. The risk of that happening seems higher now.

On the day the RBI released the monetary policy statement keeping the repo rate unchanged for the third bi-monthly meeting in a row, the central bank’s inflation expectations survey showed that households expected current inflation to be as high as 8.9%, 10% three months from now and 10.3% a year from now.

For the sixth round in a row, this bi-monthly survey of 6,047 households found food inflation to be the biggest contributor. The survey also found that consumer confidence declined marginally in the latest round after increasing through successive rounds over the last two years. A change in sentiment, perhaps? Another reason for the RBI to start worrying.

Some reservations about ratios… and proportionality

While he kept the repo rate unchanged, RBI Governor Shaktikanta Das announced a ‘temporary’ increase in the cash reserve ratio (CRR) of 10% of the net increase in aggregate banking system deposits between 19 May and 23 July. That would likely suck out an estimated ₹1 lakh crore of excess liquidity from the system, which has accumulated due to the return of ₹2,000 denomination notes that the RBI announced in mid-May.

Its impact on banks’ lending and investment decisions is unlikely to be significant, though it could give some management pause. Its effect on the upcoming auction of new 10-year government securities will be interesting and indicative of how banks perceive the measure.

Uncertainties remain, of course, the most immediate being the monsoon. As the RBI and the India Meteorological Department have observed, rains have made up for the loss caused by a delayed start to the monsoon, but distribution has been skewed. Here’s another question for consideration: what if the monsoon stays well beyond its anticipated end? This is not inconceivable, given the extreme weather changes that have occurred globally.

That could disrupt the upcoming harvesting and sowing cycles. Extended rain could destroy other vegetables and cause price shocks. The prices of pulses have already been rising consistently by double-digit percentages for more than two years; the MPC has also pointed to the potential for crude oil prices to rise suddenly.

Inflation dynamics have started to shift again. Global conditions are beginning to make their presence felt. India may have benefited from cheap Russian oil supplies, but that’s not a permanent situation. Jayant Varma has consistently underscored global risks like climate events and crude oil shocks more than a few times.

History provides perspective…

At its June 2019 meeting, the MPC changed the monetary policy stance from neutral to accommodative; it persisted with that stance till August 2022. It kept the repo rate unchanged at 4% from August 2019 to June 2022. That stance has had more than two years for transmission to play out fully, before there were a series of rapid interest rate changes that raised the repo rate to 6.5% in February 2023.

The policy stance has also changed to withdrawing accommodation, mainly through open market operations and standing facilities. In essence, the central bank settled to drain excess liquidity in the system and brought that down substantially without compromising access to credit.

The RBI faces a tough, perhaps even cruel, trade-off. For several months, it maintained an accommodative policy stance to stimulate growth. It succeeded, but now, it has to protect that growth, while also controlling inflation. It has to do so against a backdrop of supply-side constraints and disruptions that haven’t quite been fully resolved.

Inflation stubbornly stayed above 5% in FY23, and is likely to average 5.2% in FY24. While that is within the band of 2-6% as mandated, it is still too close to the upper limit, and for too long. Households’ inflation expectations could very well get even higher. Can the RBI still protect growth?

The US Fed has gone through an accelerated programme of hikes, to deliberately create a recession, though a manageable one: the so-called soft landing. It might be able to do that. The UK, despite some near brushes with bank failures, has managed to raise rates but undertake asset purchases at the same time to prevent a collapse in the housing market.

Rather than treat it as a trade-off, perhaps the central bank will have to address growth and inflation separately using different instruments to tackle each side. Rather than walk a tightrope between growth and inflation be the big cat that walks a dual set of parallel ropes. It will take some strength, but it can be done.