RBI can follow these two examples to tackle soaring inflation, but will it take the risk?

Can spiralling fuel and food prices, which have led to a spurt in India’s Consumer Price inflation, push the Reserve Bank of India to act up?

Since the pandemic began, the apex bank, much like other central banks, has looked at managing growth by adding liquidity. Most emerging and developed nations are reeling now under soaring inflation. In the case of the US, the Federal Reserve resorted to unprecedented printing of money for doling out Covid cheques to its citizens. The US Fed balance sheet has ballooned to $7 trillion.

In India, data from the ministry of statistics released on Monday suggests CPI rose to 6.3 percent on a yearly basis in May 2021. Core inflation which excludes categories such as food, fuel and power was up by 6.34 percent for May 2021– highest growth since July 2014. Both the headline and core inflation numbers are slightly above the inflation target of 2-6 percent (4 plus or minus 2) that the RBI monetary policy committee and the government agreed to achieve until 2026.

The soaring inflation has been felt by the average motorcyclist waiting at the petrol pump; Deposit-holders feel it when they calculate the interest returned. Lucky folks who have been unhurt by the soaring inflation can simply walk-in to the nearest sabzi-mandi (please mask-up and do not crowd) to get a first-hand experience of the discontentment. Fuel has turned expensive and so has cost of Potato, Cabbage, Cereals, Pulses, Meat, other vegetables and fruits. Even, health expenses have turned costlier.

What’s FUELing Inflation?

Rising crude prices and the landing price of Petrol and Diesel could be to blame for the soaring inflation in India’s case. The tax component on a litre of diesel or petrol is as high as 65-70 percent. The RBI in its recent Jun’4 meeting batted for a co-ordinated approach to control spiralling prices. “Excise duties, cess and taxes imposed by the Centre and States need to be adjusted in a coordinated manner to contain input cost pressures emanating from petrol and diesel prices,” it said.

With the OPEC revealing its inclination to increase Crude prices, commoners are likely to spend more on petrol. Commodity prices too have shown a nudge and this is likely to augment the supply related concerns for businesses. Another factor concerning businesses is a disruption in availability of labour.

What may work for MPC is the uplifting of lockdowns and curfew like scenario which had previously affected the supply-side of businesses. Many states that have unlocked in June are working at speed to vaccinate as many citizens as possible. However, the threat of a third wave and subsequent lockdown looms large and may keep the RBI on its back-foot.

What are other Central Banks doing

The current CPI Inflation, unlike current Wholesale Price Inflation, is still in single digits. That does not seem to worry

India’s apex bank much but central banks across the world have given raising interest rates a serious thought. The US Fed has suggested it will raise rates. The Brazilian central bank, for instance, has been raising lending rates since the start of the year and is likely to come up with a more steeper raise in August.

The Brazilian central bank believes in nipping inflation in its bud before it becomes uncontrollable. The RBI admits to a spurt in inflation across emerging economies. “CPI inflation is firming up in most AEs, driven by release of pent-up demand, elevated input prices and unfavourable base effects. Inflation in major EMEs has been generally close to or above official targets in recent months, pushed up by the sustained rise in global food and commodity prices. Global financial conditions remain benign.” reads the latest note from the RBI MPC.

The apex bank could be squeezed into deciding what to choose – focus on inflation and ease the common-man’s life? Or, focus on growth in the economy.

What the RBI could do?

Central banks across the world are showing urgency in tackling inflation. At least the Brazilian Central Bank has already begun some work.

An SBI Ecowrap report suggests the objective for the RBI — “repairing the supply chain remains the top priority on which the RBI has little control – the Government of India needs to step in a big way. If the RBI has to ultimately increase interest rates / change its stance to combat inflation, it may impact any incipient signs of recovery; on the other hand, being a mute spectator can seriously impair RBI’s credibility in fighting inflation.”

But, the MPC’s own admission from its recent meeting indicates that inflation may not even feature as a subject in the next meeting unless ofcourse there is alarming data. On inflation, the recent MPC observed)– “A normal south-west monsoon along with comfortable buffer stocks should help to keep cereal price pressures in check. Recent supply side interventions are expected to ameliorate the tightness in the pulses market. Further supply side measures are needed to soften pressures on pulses and edible oil prices. With declining infections, restrictions and localised lockdowns across states could ease gradually and mitigate disruptions to supply chains, reducing cost pressures. Weak demand conditions may also temper the pass-through to core inflation. Taking into consideration all these factors, CPI inflation is projected at 5.1 per cent during 2021-22: 5.2 per cent in Q1; 5.4 per cent in Q2; 4.7 per cent in Q3; and 5.3 per cent in Q4:2021-22; with risks broadly balanced.”

The SBI Ecowrap report expects the RBI to hold the interest-rates in August. “We believe RBI would still try to find a marriage of convenience of regulatory and developmental measures and monetary policy in August policy. The die has been cast, but the RBI can still hold out with a firm message of ratcheting up of inflationary pressures in August policy statement. On a separate note, India must meaningfully vaccinate a large segment of the rural population in Q2 so that it can effectively beat the new mutant strain in the town,” the report adds.

In the wake of rising petrol prices and higher than expected vegetable prices, the RBI may be prompted to look at two examples as inspiration for raising interest rates.

An International Inspiration:

Late US Federal Reserve’ Chairman Paul Volcker is credited for having attempted to tackle inflation rather than growth. He succeeded restricting double digit CPI inflation in the US during the 1980s by focusing on hiking lending rates and restricting the money flow. But Volcker’s policy-resulted in unexpected short-term effects such as unemployment and farmer unrest which further snowballed into political attacks.

The prime lending rate in the US touched a whopping 21 percent in 1985. It restricted consumer spending and naturally the industry outlook for banking, auto and real estate were struck badly. A heavy interest rate kills the morale of even desperate buyers.

Volcker headed the Economic Recovery Advisory Board under the Obama administration between 2009-11 and remained a towering figure despite the criticism of the Volcker rule and his pursuit of more regulatory pressure on banks.

Nearly a year ago, Viral Acharya, who calls himself the poor man’s Raghuram Rajan, reminded the RBI to focus on inflation which has breached the RBI’s threshold level a few times in the past. Can the RBI take some cues from Volcker? If going the Volcker way appears fraught with risks, there’s an easier in-house inspiration.

In-House inspiration:

D Subbarao, the former RBI governor, torn between Growth and Inflation, tried solving the latter. In 2010, bad monsoon dented India’s agricultural output which further increased inflation to unprecedented leves. Subbarao was welcomed with a growing economy but soaring inflation.

To the disappointment of the markets, Subbarao batted for increasing lending rates during periods of high growth. He had famously remarked that inflation was a “regressive tax on the poor”. Repo rate during his term saw a downward revision of 9 percent in Sept’08 to 4.75 percent in March 2010. From there it was systematically revised to 8.50 percent until March 2012.

In 2013, an ET report cites the governor lucidly expressing the problem of the common man — “I have sympathy with that view (that high interest rates was hurting growth). I am not saying that’s an invalid criticism. But I just want to say that their voice is heard, but people who are hurt by inflation – the large majority of the poor – their voice is not heard.”

Hearing a poor man is easier said than done. Volcker and Subbarao took upon bigger risks despite umpteen repercussions. Subbarao who worked with two Finance Ministers – former President Pranab Mukherjee and former Finance Minister P Chidambaram, received flak, majorly for having an independent mind and the inability to support the currency. The Indian Rupee, under his governorship, breached levels of Rs 49 and touched its lowest of Rs 68 during the last days of his term. In his book, “Who Moved my Interest Rate?”, Subbarao details how a co-ordial relationship with PC turned frosty owing to raising of rates.

The RBI stuck between Growth and Inflation may find the former lucrative to address. A Covid struck India saw GDP decline by 7.3 percent. Better growth outlook will keep the markets happy — sell more cars, motorcycles, retail products and keep the stock markets enthused. A better GDP growth rate will also help build a comparision narrative over neighbors like Bangladesh and China. But focusing on inflation and raising rates will hurt consumer buying and may even rub markets in the wrong way.

But then history is kind upon those who have acted with their mind.

The RBI MPC is expected to meet between Aug 4-6 to deliberate on the monetary outlook.