Early signs of second-order effects: RBI cannot ignore price pressures

Some economists have argued in recent weeks that the economic momentum in India is slowing. The “State of the Economy” article in the latest Monthly Bulletin of the Reserve Bank of India (RBI) — though it does not reflect the view of the central bank — argues that it appears the slack observed in the second quarter is now over. Private consumption is again driving domestic demand, though the picture is mixed. RBI economists expect real gross domestic product to grow 6.7 per cent in the second quarter and 7.6 per cent in the third quarter this financial year. The official estimate for the second quarter will be released next week. However, one of the highlights of the article was its analysis of inflation conditions, which is being debated across various forums.

 

The view that the Monetary Policy Committee (MPC) should ignore food prices while determining the policy rate has again resurfaced, with calls for lowering the policy interest rate, including by senior government functionaries. In this regard, it is worth examining the inflation condition and the position of the RBI. The consumer price index (CPI)-based inflation rate increased to 6.2 per cent in October, as against 5.5 per cent in the previous month. Notably, CPI food and CPI core recorded a month-on-month increase of 2.2 per cent and 0.6 per cent, respectively. While the food inflation rate has largely driven the headline rate in recent months, the core rate too increased in October. The core inflation rate in October was 3.8 per cent. Worryingly, RBI economists have highlighted early signs of second-order effects or spillover of high food prices. There are signs of “cost of living” pressures beginning to get transmitted into wages in some segments. While the headline rate is expected to moderate in the coming months, the generalisation aspect will need to be closely watched.

 

It is worth highlighting that even if the headline or food inflation rate comes down, it will only reduce the pace of price increase and consumers will continue to pay comparatively high prices. Given the sustained price increase in recent years, particularly in the food segment, it may continue to affect wage negotiations. It is thus important for the central bank to anchor expectations through efforts to align inflation outcomes to the target as quickly as possible. In terms of growth, the Bulletin rightly points out that high inflation is affecting consumption demand, with implications for corporate profits and capital expenditure. Thus, it is important to keep inflation in check for sustainable higher growth.

 

Given that early signs of spillover from food are beginning to emerge, a premature rate reduction could affect expectations and result in the generalisation of inflation. The RBI made the mistake of ignoring food prices in the early 2010s, resulting in inflation getting broad-based. A repeat will be best avoided. In any case, the legally binding target given to the RBI is headline inflation. In terms of the possibility of cuts in the policy rate, the baseline-inflation projection of the RBI for the fourth quarter of 2025-26 is 4.1 per cent, which is close to the target of 4 per cent, and may open up space for rate reduction next year. However, if growth momentum indeed slows as some economists expect, the clamour for rate cuts will only increase. The MPC will need to remain focused in such a situation.