Cars

Inflation conundrum: The need to tackle supply-side disruptions without dampening economic recovery – ET Auto


On May 4th, RBI caught the country by surprise by announcing a 40-basis point increase in the policy repo rate. In addition, RBI increased the CRR by 50 basis points to 4.5%. The announcement was made after an emergency meeting of the Monetary Policy Committee. Later, on the same day and after the RBI announcement, the US Fed announced a much-anticipated increase in interest rates, though by 50 basis points. A rate increase was also announced by Bank England on May 5th. The consumer inflation is at 7% (over the 2-6% target band of RBI) and WPI inflation at 14%, implying negative interest rates. Higher interest rate results in fewer people wanting to borrow money and increased CRR means that banks have less money to lend.

The hike has come against the backdrop of an economic recovery. While the GDP is currently projected to grow at over 7% in the coming financial year, the economic recovery in India is still nascent. A few days ago, the RBI’s report on currency and finance said, “Both private consumption expenditure and investment marginally surpassed their pre-pandemic levels in 21-22….” Exports and Government expenditure have seen brighter spots driving the economic recovery. Further, the future global and Indian economic growth projections have been revised downwards by many agencies (including RBI itself) since the onset of the conflict in Ukraine.

The RBI in its commentary has attributed high levels of inflation to external factors i.e., high commodity prices, disruptions in global supply chains including the account of lockdowns in response to fresh COVID waves, and export restrictions by key producing countries. Further, RBI has also said, “Heightened uncertainty surrounds the inflation trajectory, which is heavily contingent upon the evolving geopolitical situation.”

Since the onset of the conflict in Ukraine, the Rupee has marginally declined from Rs 74.5 to a dollar to Rs 77 a dollar. RBI has intervened in the foreign exchange markets to support the Rupee. The foreign exchange reserves have declined from approximately $630 billion to less than $600 Billion. The cost of imports of commodities, especially crude oil is up. January and February 2022 saw $10 billion of FPI outflows from India. Numbers for March and April have not been released by the RBI. With higher interest rates in western countries, there is a risk of outflows from India. It is, therefore, possible that the timing of the RBI rate increase could have been influenced by the anticipated increase in global interest rates and the need to defend Rupee to combat both inflation and address economic risks.

There are also questions on the quantum and timings of future monetary tightening. How will the RBI react to further increase in interest rates (as per current indications) by central banks in developed economies? Should negative real interest rates be allowed over a protracted period? While negative real rates are good for borrowers, they are a big disincentive for individuals with savings.

High inflation is also being experienced in developed countries, though in contrast to India, it is driven by both the demand side (due to unprecedented stimulus and growth in central bank balance sheets) and supply-side issues (such as rising wages). Therefore, the question for India is whether the increase in interest rate will address inflation caused by supply-side disruptions and whether this could slow the economic recovery by dampening consumption and private investment.

Given the role of imports, commodities, and external factors in inflationary pressures, monetary policy alone may not be able to bring down inflation. Fiscal and other policy measures may need to be evaluated.

As an example, should fuel taxes be reduced further to bring down fuel prices and dampen inflation? Is there a case for a reduction in import duties for some of the commodities? In October 2021, Government has reduced the import duties on palm oil, soy oil, and sunflower oil. There are reports that the US Government is considering a reduction in some tariffs to combat inflation.

An increase in GST rates at this point could be avoided from a macro-economic perspective. They would further drive inflation and dampen consumer sentiment. Given the increase in nominal GDP growth, higher tax revenues and downward pressure on the debt to GDP ratio should provide greater fiscal headroom to the Government.

To conclude, the global economy is passing through a period of great uncertainty due to geopolitical conflicts, continuing impact of COVID, and the aftereffects of the monetary stimulus in developed markets. These actions are impacting the lives of Indian citizens. In addition to monetary policy tools, the Indian Government should use all other policy tools to contain inflation and minimize the downside risks to the Indian economy.

The writer is Associate Partner, Tax and Economic Policy Group, EY India.




Source link

Related Articles

Back to top button