For Reserve Bank of India (RBI) governor Shaktikanta Das, inflation has turned out to be a much bigger dilemma than many had anticipated earlier.

The unexpected rise in retail inflation to 6.3% in May, announced on June 14 by the National Statistical Office (NSO), has brought the focus back on the growth-inflation dynamics once again. At a six-month high and above the upper band of RBI’s target range, it has raised some alarms. More importantly, the core inflation (which removes volatile components of food and fuel prices from the basket of commodities tracking headline inflation, and a better indicator of demand-supply mismatch of goods and services) has swelled to almost a seven-year high at 6.6%.

At the Monetary Policy Committee (MPC) meeting, held just 10 days ago on June 2-4, inflation calculations were still showing the prospects of a controlled, range-bound spike. April's inflation at 4.23% was more or less in line with its expectations. The evidence then suggested that inflation was being driven by supply-side factors including the global surge in commodity prices, and not by domestic demand. Nobody thought the retail inflation had already gone through the roof in May.

At the meeting, the focus was to moot the economic growth as the second wave of Covid-19 pandemic swept through the country, bringing economic and industrial activities to a temporary halt. The March quarter reported a 1.6% growth in GDP. The localised but stringent lockdowns across several states had led to a fresh round of job loss and a significant dent to the demand.

At the wholesale price index (WPI) level, there have been general price pressures and risks. The WPI-based inflation jumped to 10.49% in April from a contraction of 1.7% in the year-ago period, with inflation for fuel and manufacturing items leaping to 20.94% and 9.01% respectively. However, the passthrough of cost-push inflation at the retail level had remained muted amid an overall demand deficiency. So, what saved the situation is a dip in demand in the pandemic. In addition, the credit growth too remained anaemic.

The MPC reviewed the surveys conducted by the central bank to gauge consumer confidence, households’ inflation expectations, corporate sector performance, credit conditions, the outlook for the industrial, services and infrastructure sectors, and the projections of professional forecasters.

Das was relieved that the headline inflation had moderated to 4.3% in April from 5.5% in March. He believed that it gave the central bank some policy space to step up liquidity infusion into the system to provide further support to the weak domestic economy. Reviving and sustaining growth on a durable basis was the mantra.

“Large base effects played a crucial role and inflation sobered across food as well as core groups,” Das told the committee. He believed the fragile demand conditions could help limit the pass-through of input cost pressures across manufacturing and services to output prices.

The inflation measured as consumer price index for FY22 was projected at 5.1%, which was well within the RBI’s mandated tolerance band of 2-6%.

“However, we would need to keep a close watch on the evolving trajectory considering the uncertainties, both on the upside and downside, to the baseline path. Given the predominant role of supply-side factors in the recent inflation movements would be critical to bring about a durable softening of price pressures,” Das said, referring to the supply-side policy measures with regard to petrol and diesel, edible oil and pulses.

While voting for a pause on the repo rate, Das said the second wave-induced dent on economic activity has necessitated the continuation of monetary measures to support the process of economic recovery. “The emphasis should be to continue with an accommodative stance as long as necessary to revive and sustain growth on a durable basis and continue to mitigate the impact of Covid-19 on the economy, while ensuring that inflation remains within the target going forward,” he said.

The committee agreed unilaterally. It decided to keep the policy repo rate unchanged at 4% and the reverse repo rate unchanged at 3.35%.

Amid the fear of a spike in inflation, which is already at an elevated level, a few of the committee members cautioned against erring on inflation both on upside and downside and stressed the need for being purely data-driven. Two committee members emphasised the need for appropriate and credible reaction function in case of upside turns in inflation.

“To maintain and enhance this credibility, the MPC needs to remain data driven so that it can respond rapidly and adequately to any unforeseen shocks that may arise in future,” said Jayanth R Varma, an MPC member and professor at IIM Ahmedabad, who joined the meeting through video conference.

The inflation rates, according to Varma, have been consistently well above the midpoint of the tolerance zone for an extended period and are forecast to remain elevated for some time. “Moreover, survey data and other indicators show that businesses have no difficulty in passing on cost increases to consumers, and are able to maintain (and even expand) their margins.”

According to him, the only source of comfort is that all the evidence at the moment suggests that inflation is being driven not by domestic demand, but by supply-side factors including the global surge in commodity prices. “This could change as the recovery gathers steam, and the MPC must be sensitive to the risk that inflation expectations could become entrenched if inflation remains elevated for too long,” said Varma.

Mridul K Saggar, RBI executive director and part of the committee, said there are risks to inflation as there have been general price pressures at the WPI level. “However, the passthrough of cost-push inflation at the retail level has stayed muted amid demand deficiency,” he said.

“In my view, clear signs of generalisation in CPI inflation setting in could be a tipping point where growth-inflation dynamics could alter. Also, with a further rise in elevated inflation expectations, policy may need to respond if these expectations are becoming unhinged. While the odds are that we can avert this as inflation softens back in H2, the uncertainties ahead provide a rationale to avert any time-based guidance, especially as transmission lags exist,” said Saggar.

Thanks to the inflation shock in May, stock brokerages, analysts and economists have raised their forecast. Nomura analysts Sonal Varma and Aurodeep Nandi said in a note that they now expect CPI inflation to average 5.6% year-on-year in 2021, up from 5% earlier, and core CPI inflation to average 6.2%, up from 5% earlier.

Icra Ratings raised the forecast for the FY22 average retail inflation to 5.4%-plus. Emkay Global said it expects core inflation to remain high, outdo headline and average comfortably above 6% in FY22. It expects the headline inflation to be around 5.5%.

Everyone believes that the central bank will continue to wait and watch as a rate hike is out of question for now.

“One may have to wait for the June 2021 retail inflation number to assess the RBI’s next policy action,’ says CARE Ratings

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