The Challenge of Inflation Amid a Massive Shock to Our Economy

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.