MUMBAI: Retail inflation at 18-year low in June sounds alarming and strengthens the case for rate cuts. But look closely. Inflation isn’t falling. It’s going up.
The misconception is because inflation is widely misread.
It’s a measure of how much more we pay than last year to achieve the same level of well-being.
Inflation is measured every month, but DOES NOT reflect sequential change – the price difference of this month over the previous month – but for say June, 2016 to June, 2017.
When the data comes out, it’s invariably compared with previous month leading to divergent views than that of the RBI’s. Retail inflation in May was 2.18 per cent and June’s 1.54 per cent makes you believe it’s in a free-fall mode.
But, if you see month-on-month data, prices are going up. From January’s 130.3 points, general inflation index in June printed at 132.1 points. Ditto with food inflation, partly explaining why monthly budgets have no respite from ‘falling’ inflation.
Inflation also reflects a change in the base price, not accurate prices. Tomatoes retailed at Rs 3,000 per quintal in Bengaluru both during June 2016 and 2017, but in reality, prices rose, which economists blame on seasonal gyrations. “Vegetable prices remain sticky every monsoon. That’s nothing new,” says Dr Sowmya Kanti Ghosh, Chief Economic Advisor, SBI Economic Research.
Food and fuel account for 57 per cent of the CPI basket, but its direct influence on monetary policy is limited and that’s why the RBI seems unperturbed. Low inflation breeds weak economic activity and a rate cut can boost spending and investment, which is why the Ministry of Finance has been pushing hard for cuts.
The dominant view is that the RBI is moving too independently, and isn’t seeing what everyone else is experiencing. “Because inflation is incorrectly compared to previous month’s data, the clamour for rate cuts is growing, but the Central bank takes a logical view,” reasons Madan Sabnavis, Chief Economist, Care Ratings.
Critics are also pontificating about RBI’s error-prone inflation projections, conveniently overlooking the inflation target itself. Strictly speaking, the RBI’s Monetary Policy Committee (MPC) has to maintain annual inflation of four per cent, with a plus/minus of two per cent. The MPC pegged inflation at 2-3.5 per cent for April-September.
It means, June’s 1.54 per cent is well below RBI’s lowest band of 2 per cent, but if you take the first quarter (April-June), there’s no breach. In fact, the RBI and MPC scored quite a success, smoothly gliding down to the 2-4 target (from 7-8 per cent in 2014) in record time, but holding it here is a challenge.
Interestingly, the inflation targeting mechanism was proposed by none other than the RBI Governor Urjit Patel himself. As Deputy Governor in 2014, he chaired the MPC Framework Committee, whose recommendations – including MPC creation and replacing WPI with CPI – were duly adopted in 2015 and 2016.
Importantly, three of the Patel Committee members namely Patel himself, Prof Chetan Ghate, and RBI Executive Director M D Patra — are now part of the six-member MPC and to misinterpret and underestimate the collective wisdom is jumping the gun too soon. This isn’t to say the MPC is fool-proof. Even with a clear target, suitable instruments and insulation from outside pressures, it cannot possibly foresee all contingencies (demonetisation, GST). Eventually, its decision depends on judgment and discretion.
Now the rate cutting part. As eminent cartoonist R K Laxman once poignantly noted, for every ill, the only cure is for the RBI to cut rates. Since January 2015, policy rates are sliced to the bone by 175 bps, yet private investment is poor. How effective will a 25 bps cut next month is anybody’s guess. RBI Deputy Governor Viral Acharya, who’s plumbing the banks’ punctured balance sheets, last week made his views clear: cleaning up bad loans as a priority over rates.
What does the rest of the MPC think? We will know soon.
Inflation challenges
If the MPC fails its inflation target of four per cent (+/- 2 per cent) for three successive quarters, it will have to issue a public statement, signed by each member, stating the reason(s) for failure, remedial actions proposed and the likely period of time over which inflation will return to the centre of the inflation target zone.