The Challenge of Inflation Amid a Massive Shock to Our Economy

Livemint     10th September 2020     Save    

Context: Persistent price pressures make it harder for our central bank to manage conflicting economic forces and ensure stability.

Facts about the current state of inflation in India

  • India as an Inflation Outlier: 
    • Indian consumer price inflation has averaged 6.7% in the first seven months of 2020.
    • India is one of the few large economies where inflation has actually gone up since the start of the pandemic.
    • Only three other major economies have consumer prices growing at a faster clip—Turkey, Pakistan and Argentina.
    • Stagflation: A toxic mix of high inflation and falling output.
  • Possibility of an “inflation whipsaw”:
    • On the upside, a perfect sum of cost-push pressures, accommodative monetary policy, and adverse food supply shocks could lead to a pickup in inflation.
    • On the downside, forced saving pressure induced by a ‘de-facto’ lockdown, could be a potent disinflationary force.

Four competing explanation of rising inflation

  • Severe Supply dislocations during the national shutdown as compared to demand destruction.
  • High-frequency data shows that transport services are still taking time to normalize.
  • Idiosyncratic factors: Rising gold prices, tax increases on fuel, upward-bound liquor prices, food inflation was pushed up by higher prices of select farm produce such as potatoes and tomatoes.
  • Accommodative monetary policy: 
      • Reserve money grew by 14.7% while the stock of broad money grew by 12.6% in August - latest data from the Reserve Bank of India (RBI).
  • Expanding currency demand (23.1%) rather than bank deposits (10.8%).
  • Higher prices of import goods

RBI’s Dilemma between targeting the exchange rate or money supply: is exacerbated by -

  • Rising forex reserve and narrowing of the fiscal deficit: has forced the RBI to buy dollars to prevent the rupee from appreciating

Conclusion: The coming months will present RBI with many challenges, as the central bank has to maintain both internal as well as external stability in the midst of a massive shock to the economy.