INFLATION TRADEOFF
The surprise move by RBI last week to fend off the threat of inflation and shore up the rupee has set in play difficult trade-offs. EPISODE #72
Dear Reader,
A very Happy Monday to you.
Last week the Reserve Bank of India (RBI) went off script and announced a hefty 40 basis point increase in the repo rate—the interest rate at which the RBI lends to commercial banks and hence the effective floor for interest rates—and signalled that there was more to come. The fact that RBI took the decision at a specially (and secretly) convened off-cycle meeting of the Monetary Policy Committee increased the element of surprise and confusion.
Nonetheless, the move has put the spotlight on a series of trade-offs: growth vs inflation; producers vs consumers; EMI vs retirement earnings to name a few. One person’s gain is the source of pain to another, suggesting that the fallout of the move to jack up rates is complicated. So this week I visit these trade-offs to understand the political economy of RBI’s abrupt actions.
This week’s cover picture is a wall-art from a restaurant. Hope it appeals to you too.
A big shoutout to Balesh, Aashish, Niranjan, Premasundaran, Gautam, Karan and Vandana for your informed responses, kind appreciation and amplification for last week’s column. Gratitude also to all those who responded on Twitter and Linkedin. Reader participation and amplification is key to growing this newsletter community. And, many thanks to readers who hit the like button😊.
THE RBI ANTIDOTE
Last week the Reserve Bank of India (RBI) surprised everyone with its off-cycle decision to increase the repo rate by 40 basis points. Not only did the RBI advance a meeting of the Monetary Policy Committee (MPC)—the apex group chaired by the RBI governor which decides on interest rates—scheduled for next month, it also took care to convene it secretly.
What compounded matters was the decision to announce the rate hike during market hours—the Sensex crashed by over 1,000 points as traders scrambled to cut their losses. Days later the market continues to be spooked.
At its core the RBI actions are clearly a first in the series of (likely) future increases which not only seek to head off the threat of inflation and the run on the rupee, but also initiates the process of normalisation—gradual withdrawal of the stimulus it had put in place when the covid-19 pandemic had struck India little over two years ago—of the monetary circumstances Basically a course correction as the economy slowly and steadily recovers.
Frankly, the rate hike was a foregone conclusion. The big surprise was that the MPC did not do so in its policy review last month. In fact, several experts had begun to argue that RBI was behind the curve in its policy response.
To most of us the RBI move is baffling. Especially if you peruse proxy variables—Goods and Services Tax (GST) collections and exports—capturing economic growth. Almost all of them are doing well. So why fix something when it is not broken. Indeed these numbers are impressive, but what is ignored is that rising inflation is amplifying their recovery.
For instance, GST is a consumption tax and hence levied at the point of sale. If prices of goods go up so do the collections. Further GST is levied on imports, which have witnessed a sharp uptick and increase in costs as the rupee depreciates. Yes, economic activity is picking up and in fact is better than pre-covid levels, but it needs to be sanitised for the income effect of inflation.
Clearly to RBI the threat of inflation is for real. Unchecked it could pose a serious threat to the Indian economy and undermine its medium term prospects as well. The Ukraine conflict is unlikely to end soon, suggesting that the up-cycle in crude oil and food prices is likely to gain momentum—the union government has limited options in dealing with this challenge of imported inflation.
Exactly why the RBI did two things
Initiated normalisation of monetary policy by starting the winding down of the stimulus it had put in place in the post-covid phase to shore the economy;
Signalled the start of a rate hike cycle.
Trade-offs
At the same time the central bank’s decision has put the spotlight on several trade-offs, all of which have implications on how the fallout will be distributed among the people who are yet to recover from the devastation caused by the once in a century covid-19 pandemic.
As I pointed out in the introduction, one person’s gain is another’s loss. I will cite a few to argue the case that the fallout of inflation is never uniform.
Growth vs Inflation:
The most obvious trade-off is the one between growth and inflation. Modern economic history of India is replete with instances of mismanagement of this trade-off leading to a crisis.
This has to be calibrated therefore. The logic is very simple: rapid economic growth means there is less money to chase goods; consequently the demand-supply match will happen at a higher price level.
One way to curb inflation is for RBI to raise the cost of money—interest rates. This discourages demand and thereby slows down economic activity. Here again lies a rub: slowing economic activity puts the squeeze on household incomes, while high inflation erodes the value of their incomes.
The trick here is for RBI not to overdo the monetary tightening, which could prove counter productive—yes inflation would be tamed, but growth would have been sacrificed.
This fine balance is an easy advisory to hand out but an extremely difficult act to follow. Especially since economic data is not available in real time and are also not very reliable. RBI’s task is therefore akin to flying blind in bad weather.
Pensioners vs EMI:
One big grouse when interest rates were dialled down to stimulate a growth revival was that it hurt pensioners who relied on fixed-rate investments. Worse after inflation accelerated in recent months the pensioners ended up earning negative rates of return, eroding the value of their pension corpus.
Yet, if you were to ask the scores of middle class who have taken out loans to fund their acquisition of either a house or a consumer good, lower interest rates imply lesser outgo on repayments. In fact, a negative rate of interest is an incentive to take out fresh loans.
The thing is that in either situation the dice is loaded against pensioners. The only difference being that high inflation bites harder as you go down the economic deprivation ladder.
Buyer vs Sellers:
One reason for the recent spurt in inflation, including in India, is the surge in commodity prices. The Ukraine-Russia conflict worsened an already bad situation—commodity prices were just entering an up-cycle. Two commodities that bore the brunt of this supply chain disruption were food grains and crude oil.
Given that India has been employing a pass through of higher oil prices, consumers have had to deal with higher prices at the petrol pump. On the other hand, for refiners this is a windfall as their costs remain the same while the sale price is seeing a huge upswing.
Similarly, in the case of food grains it is bonanza time for the Indian farmer—not only are they netting higher prices domestically they are also taking a shot at the lucrative overseas markets.
The consumer story however is a contrast. Mercifully the ongoing free food grains programme for 800 million people (extended till September) has spared bulk of the Indian population the other side of this broadsword. However since inflationary expectations feed off each other the downside risks of a spurt in food grain prices spilling over to other commodities is very real.
In the final analysis it is hopefully apparent that the axe of inflation falls differently for each cohort. An inflation spiral however can be devastating for all. Hopefully RBI’s response, belatedly, may spare India this experience.
Recommended Reading
Keeping with the theme for this week I am sharing the transcript of an interview Chetan Ahya, Chief Asia Economist & Global Head of Economics, Morgan Stanley, granted to the Economic Times.
It is fairly comprehensive and addresses the most asked question: Is India looking at stagflation/recession?
“We have seen that a stagflation impulse emerge even more loudly with the invasion of Ukraine by Russia and that is still reverberating through the global markets and we still continue to have commodity price pressures.
But we would not call the outcome of the state of the economy as stagflation because we are still seeing expansion in various parts of the world, especially in the US, which is an important economy to qualify us to be in stagflation or not.
One important variable that we would look at as a stagflation marker is rising unemployment. Right now we do not have that. I would say it is a case of moderate growth and high inflation rather than a state of stagflation.”
Hopefully this teaser will tempt you to read the entire interview. In case you do please click this link.
Till we meet again next week. Stay safe.
Superbly well articulated.
Anil taking action against hoarders and blackmarketers is within the control of the government agencies. Genuine spike in prices, triggered by the war, is something that we have to bear with but the situation is being further compounded by unscrupulous traders.