Fiscal pill to cool inflation fever

The increase in headline inflation in February was driven by a further rise in food and beverage inflation, while core inflation (CPI excluding food and fuel) also remained stable. Inflation in cereals rose to a four-month high of 6.26%, driven by skyrocketing food inflation, which touched a record high of 16.7%, offset by a decline in protein inflation and vegetable deflation.

A headline CPI above the RBI’s comfort zone and a sticky core inflation strengthen the case for an additional rate hike by the central bank in April. But there are limits to how high interest rates can go before they start curtailing growth. The transmission of higher borrowing costs has started affecting business sentiment, especially in the manufacturing sector. Furthermore, the collapse of Silicon Valley Bank shows that the banking system is not immune to such aggressive rate tightening and that it will eventually spread throughout the economy. Persistently high food inflation raises the question whether monetary tightening alone will be enough to tame the beast of inflation. In such a scenario, along with the supply side issue, a fiscal response may also be required.

India’s inflation is different from other economies with a much larger share of food in the CPI basket and, therefore, calls for a more strategic battle than just a monetary policy response. Aggressive rate hikes alone and the consequential fall in aggregate demand may not be sufficient to contain supply-side inflationary pressures. Therefore, fiscal struggle is necessary to control inflation. “In a country like India, where inflation is either food or fuel driven, monetary policy alone is not always sufficient. The latest CPI data shows that monetary policy has been effective only to a limited extent as it includes lag Hence, fiscal measures can be used,” said Madan Sabnavis, chief economist at Bank of Baroda. For example, further reduction in excise duty on petrol and diesel. “Yes, there has been windfall tax cut recently, but the entire benefit of the fall in oil prices has not been passed on to the end consumer,” he said.

High inflation requires greater fiscal attention, not only because of government policies to ensure price stability, but also because of the effect of inflation on the government’s budget indicators. High persistent inflation reduces the real disposable income of households and increases their dependence on government assistance programs, especially for the economically weaker sections. So far, the Center has been prudent on the subsidy front, but persistent inflation may necessitate expansion of the safety net and this could lead to higher subsidies.

Another possible impact could be on the government’s interest payments, which account for about 24.0% of total budgeted expenditure in FY2012, up from 22.5% in FY23 (Revised Estimates). Raising rates to contain inflation tends to increase bond yields, thus increasing the government’s borrowing costs and interest payments. In either case, high inflation is likely to result in an increase in non-development expenditure, thus reducing the productive spending capacity of the government, other things being equal.

Going forward, the major upside risk to headline inflation is from the food price trajectory, threatened by a renewed heat wave this year and the prospect of El Niño. Thus, there is a need for more focused and smart food supply management and proactive food grain export-import policies to contain the dynamics of supply-side food inflation.