In a popular incident in India’s most beloved epic, the Mahabharata, a master teacher, teaching archery to his royal students, asks them to take a shot at a wooden bird’s eye on a tree. He asks each of his students what they can see while taking the shot. Most answer that they see birds, leaves and the distant sky. Finally, a student says that he can only see the wooden bird’s eye. The teacher is suitably impressed by his focused student, who surprisingly grows up to be a master archer.
The story has parallels with India’s post-pandemic economy. A lot is happening. Inflation is uncomfortably high, growth is improving, new supply shortfalls are emerging, India’s double deficit is widening, and the rupee remains volatile. Should the Reserve Bank of India (RBI) focus on each of these in its policies over the next few months, or should the sole focus be on reducing inflation?
We believe that there is a case for a focus on inflation control for a number of reasons.
One, prolonged high inflation can hurt other parts of the economy. Take small firms, which employ about 40% of India’s labor force and are the weakest link in India’s recovery. Before they could fully recover from the Covid lockdown, they were hit by commodity price shocks. These smaller firms have not become as energy efficient as the larger firms, nor do they have as much bargaining power when purchasing raw materials. A Nielsen survey estimates that the number of small firms has decreased by 8% since March 2020.
In a possible scenario, if the demand for social welfare schemes picks up, higher inflation could lead to higher fiscal spending and a wider deficit. In another scenario, it can lead to a widening trade deficit if consumers buy for fear that prices will rise even more later. Finally, fears of higher inflation may also add inflation risk premium to bond yields and weigh on the rupee.
Second, some of the inflationary pressures have yet to reflect in prices. While much of India’s food inflation is driven by domestic factors such as the monsoon, some of it is driven by international food prices as well. Yet, so far only half of the regular passes have moved from global to domestic food prices. As pass-through picks up pace, domestic food prices could rise further.
Simultaneously, while manufacturers of goods have been proactive in passing on cost increases to consumers, the service industry is more hesitant. But as service providers such as restaurants begin to adjust their menu costs, inflationary pressures will mount. Similarly, rural prices have increased faster than urban prices. As electricity rates, which have a greater bearing on urban inflation, are raised, urban inflation will also rise.
Third, India’s inflation rate may not go down as soon as commodity prices begin to fall. We are concerned that prices may be a bit sticky for a number of reasons. Large corporates have gained pricing power through the pandemic. When input costs fall, will they cut the prices of the goods they sell as quickly as they raise them? Long agricultural cycles and gradual adjustments in electricity rates may also keep inflation stable.
For all these reasons, inflation is likely to remain above the RBI’s 4% target for a substantial period.
We think the policy implication is clear – that the RBI offers a range of policy rate hikes. After the 40 basis points hike in the repo rate in May, we expect another repo rate hike to 4.8% in June. Thereafter, we expect short-term rate hikes, taking the repo rate to 6% in mid-2023. Our one-year forward inflation forecast is 5.5% (in 2023-24), and the repo rate at 6% would mean that the real policy rate is a positive 0.5%, which we consider reasonable (we think this is real neutral rates of 0.5 are in the range of -1%).
A pair of dos and don’ts can come in handy along the way. Due to the wave of stagnant spending on services, the improvement in growth is currently strong. It may be relatively easy for the Indian economy to digest the rate hikes one after the other immediately. There is no point in delaying or taking a break.
It may also be a good idea to focus solely on inflation control in the policy statement—detailing the problem of inflation and the various tools to combat it. Other actions, such as the purchase of any government bond, should probably be excluded from the policy day statement. The RBI’s sense of being on a war footing with regard to inflation can go a long way in lowering inflation expectations.
As far as what not to do, we shouldn’t claim victory over inflation when the first annual number is low. Some inflation will be affected by print base effects. Instead, we should continue to watch the gradual movement with the same zeal. May inflation readings will be a case in point. Even though annual readings fell from 7.8% annually in April to 6.9% in May, as we expect, sequential readings will still advanced 11% quarter-over-quarter seasonally adjusted, annualized.
With the inflation problem clearly taking center stage, an archer’s focus can help reach optimal macro results.
Pranjul Bhandari is the Chief Economist of India at HSBC