Gear Up For Bout of Inflation

Context: The possibility of a spike in inflation in the near term is high, driven by rising global commodity prices. Monetary policy should look through it, rather than raising rates.

Factors stoking inflation

• Flood of liquidity amidst pandemic: While the governments worldwide have extended support, this has lowered the interest rates and raised the asset prices.
  • It has resulted in the phenomenon of slipping company sales and rising company stock prices. (Since policy rates are close to zero in the US and negative in Europe).
  • Liquidity has affected only asset prices and not the prices of goods and services because:
    • Goods and services are traded across borders, and most traded prices are invoiced in dollars
    • China’s ability to bring large cohorts of cheap labour to the world’s supply has been one factor.
    • Rising automation levels to offset declining labour supply and rising wages have played their role in more recent times.
    • Depressed demand, thanks to the pandemic, has been yet another factor.
• Spurt in global commodity prices: an increase in commodity prices resulting from the revival of the economy from Covid and associated restrictions can stoke inflation.
  • Global food prices are buoyant too, including a fall in crude price due to declining output.
  • A part of the rise in commodity prices is speculative: stocking up and anticipating the global infrastructure-building spree pushing up commodity prices.

Challenges to the monetary policy:

• Risk of market distortion: raising policy rates to resist the price rise would distort the output structure because the economy needs credit flow, to raise output
  • Rise in commodity prices is the signal to produce more of the commodities, boosting production.

Way Forward

• Inflation supportive monetary policy: Monetary policy should allow rising prices of raw material (like steel, iron etc.) for increasing the production of close substitutes as a result of an increase in output.
• Ensure supportive and expansionary fiscal policy:
  • Stepped-up investment would directly create demand and raise confidence, inducing greater spending and increased production.
  • Moderate rupee against the dollar: Slashing import duties, currently at an average of 14%, is another way to keep imported inflation under check.
  • Increased demand (as a result of policy rate cut-> easy credit flow ->increased investment and output ->income and wage hike) should be met with increased production, rather than a further rise in prices.