The inflationary pincer

RBI's approach to inflationary expectations may not be working

The consumer price index (CPI) numbers for April were released on Monday. They showed the year-on-year rate of inflation to be marginally higher than in the previous month, coming in at 8.6 per cent. The pattern over the past few months has been broadly stable, with no particular indication of a decline. The wholesale price index (WPI) numbers for the same month were released on Thursday. In contrast to the CPI, the rate of inflation has declined from 5.7 per cent in March to 5.2 per cent in April. The rate has been below six per cent for all four months of 2014, while, measured by the CPI, it has been above eight per cent. In the past, when the Reserve Bank of India (RBI) pegged its monetary policy stance on WPI inflation, the trend shown by this indicator would have raised expectations about a possible cut in interest rates. However, with the clear signal that the RBI now primarily focuses on the CPI, the stubbornness of inflation on that indicator virtually rules out any such move. Two questions arise, however. Having decided to work with the CPI, given its striking rigidity, will interest rates come down at all in the foreseeable future? And, while the RBI uses the mainstream monetary policy argument that reining in inflationary expectations is a critical objective of policy to justify its stance, are there signs that this approach is not working?

The answers to the two questions are, in fact, related. What the WPI does strongly suggest is that demand-side pressures are virtually non-existent. The rate of inflation in manufactured goods, which best captures this driver, even if imperfectly, has been low and steady. However, when food and energy are stripped out of the CPI with the objective of capturing demand-side pressures on the consumer front, the story is very different. Consumer inflation excluding food and energy has been at a steady eight per cent for several months. This could mean that demand-side forces are still active, which the RBI has argued, because expectations of persistently high inflation have become entrenched and the process has become self-reinforcing. This would also justify the RBI's current stance. But what if the expectations themselves have little to do with the RBI's stance? If, for example, the dominant source of high expectations is high food inflation, on which monetary policy admittedly has no direct impact, do monetary actions themselves have any influence on expectations? If not, then the RBI would have to throw its collective hands up and admit defeat. It can keep interest rates as high as it wants for as long as it wants, without CPI inflation being the slightest bit affected.

Does this mean, then, that it should lower rates to stimulate growth? Unfortunately, tempting as this inference may be, it is not necessarily correct. While lowering inflation may be proving to be a huge challenge, provoking it to accelerate will turn out to be surprisingly easy. The first sign of the RBI having lowered its priority on inflation fighting could trigger a spiral, which, historical experience tells us, is extremely difficult to contain. Frustrating, no doubt, but this is the price that the economy must pay for having neglected basic supply-side issues for so long.