Increasing inflation risks

Global uncertainty will weaken recovery

Several analysts had questioned the Monetary Policy Committee’s (MPC’s) latest inflation projections for the next fiscal year. The rate-setting committee in its last meeting in February had projected the inflation rate based on the consumer price index (CPI) to average 4.5 per cent in 2022-23. Global events since have significantly increased inflation risks, and the committee would need to make adjustments in its projections. The MPC and RBI would also need to adjust their policy stance and operations accordingly. The inflation rate in February increased to an eight-month high of 6.07 per cent, which is above the tolerance band of the RBI. 

Meanwhile, the inflation rate based on the wholesale price index (WPI) remained in double digits for the eleventh consecutive month. Although the MPC targets the CPI, the persistently elevated level of the WPI underlines the inflationary pressures in the economy.

The inflationary pressures are likely to persist in the foreseeable future. Global commodity prices, particularly crude oil, have increased significantly since the Russian invasion of Ukraine, and the imposition of an unprecedented level of sanctions on Russia. Although oil prices have come down in the hope of diplomatic progress in the context of the crisis, they are expected to remain elevated in the near to medium term because sanctions are unlikely to go in a hurry. Since the eventual outcome is uncertain and it is not clear how long the crisis will persist, economic policymakers in India would be well advised to start making adjustments. Higher crude oil and commodity prices, in general, will lead to higher inflation and lower growth in India. They will also increase pressure on government finances. Oil companies, for instance, have not passed on the increase in prices to consumers. It is possible that the government is willing to absorb part of the price increase. It may also be contemplating reducing excise duty on petroleum products. Both options will hit the Budget. If the entire increase goes into the retail prices, it will push up the inflation rate and hit consumer demand. Thus, there are no easy options. The government will also have to fund the inevitable increase in fertiliser subsidy.

The RBI and MPC will also need to make adjustments. The central bank has been supporting economic activity since the outbreak of the pandemic by maintaining lower interest rates and higher liquidity. The RBI was seen to be behind the curve even before inflation risks increased as a consequence of the Ukraine crisis. The US Federal Reserve, for instance, is expected to start increasing rates this week. In response to higher inflation, other central banks are also in the process of withdrawing excessive monetary accommodation. The RBI, too, is draining out excess liquidity from the system, which has helped push up market interest rates, but was expected to do more by now. The RBI, for instance, was expected to normalise the policy corridor, which would have made market rates more stable. A delay in withdrawing excess accommodation with the idea of either supporting growth or the government-borrowing programme can increase inflation risks and damage the longer-term prospects of the Indian economy. Overall, the global economic uncertainty will further weaken the ongoing economic recovery from the pandemic-induced disruption and increase macroeconomic challenges.