Welcome relief, but...

Lower inflation numbers do not solve RBI's dilemma

In a situation awash with bad news on the macroeconomic front, the May numbers for the wholesale price index (WPI) come as a significant and welcome contrast. The overall, or headline, inflation rate came in at 4.7 per cent year on year, lower than April's 4.9 per cent. Non-food manufacturing inflation, which the Reserve Bank of India (RBI) uses as a measure of core inflation, indicating the presence of demand pressures on inflation, stood at 2.4 per cent. Both these estimates add weight to the argument that monetary policy can continue its moves towards stimulating growth by reducing policy rates without worrying too much about setting off another bout of inflation. Many analysts expect these numbers to induce the RBI to reduce the repo rate by another 25 basis points later today.

However, in the complicated growth-inflation dynamic that has played out over the past few years, nothing is as simple as it seems. Viewed exclusively through the lens of growth and core inflation, a rate cut would be a no-brainer. Other macroeconomic developments, though, are worrying. Retail inflation in the consumer price index (CPI) has been declining, but at a far slower pace than in the WPI. Part of this is due to the higher weight of food items in the former; food inflation actually accelerated in May. But, beyond that, the retail inflation rate for manufactured goods, such as they are covered by the CPI, also remains rather high. If the consumer is not seeing much relief, then the implication is that inflation expectations and wage negotiations could contribute to an entrenchment of high inflation, notwithstanding sluggish growth. The recent depreciation of the rupee will also matter in evaluating inflationary pressure. Even after Friday's recovery, the general expectation is for persistent downward pressure, which could precipitate into a sharp decline as a result of any adverse global or domestic developments. This implies that cost pressures from unavoidable imports like oil and coal will remain, if not intensify, particularly as oil prices seem to have stabilised after a decline. Speaking of demand pressures and core inflation, other core measures, such as the Crisil Core Inflation tracker, which was reported on in this newspaper on Saturday, suggest that the decline is not as sharp as indicated by the non-food manufacturing measure.

Finally, even as government spokespersons are broadly hinting, if not explicitly suggesting, that the inflation numbers warrant a rate cut, there are issues about both policy rate cuts being transmitted by banks to borrowers and things being done by the government to speed up investment. These two factors clearly influence the balance between inflation risks and growth payoffs in the current scenario. Under the circumstances, the RBI's decision is certainly not a no-brainer. Even before the rupee began its decline, the RBI governor had said he saw limited room for easing, which has now been further constrained. The question facing the RBI is whether whatever room remains now should be used up as soon as possible, or preserved for a shift in the risk-payoff balance.