This is a guest blog by Punit Bansal.
Covid-19 has adversely affected the world economy, including India. A harsh lockdown has impacted Indian economy very badly. Reserve Bank of India has kept its accommodative stance for the last 9 months. It has taken up unconventional measures to mitigate the impact of pandemic on the economy. RBI has been on interest rate cut since a year as GDP growth was faltering even before the pandemic and the pandemic has only done a job to make the situation worse. There is no economic policy which is perfect as in an attempt to solve a problem other things also get affected, inflation is one such example. Fiscal and monetary measures pursued to revive growth sometimes end up causing high inflation in the economy.
Inflation is basically of two types “Cost-Push inflation” and “Demand-Pull inflation”. Rise in cost of production causes Cost-Push inflation and when demand exceeds the supply in the economy then Demand-Pull inflation occurs. Demand pull inflation mainly occurs due to excessive spending by the government i.e. high fiscal deficit and interest rate cut by central bank to boost demand. But in the long run inflation is considered to be caused by only increased money supply in the economy by central bank.
Consumer Price Index is used to determine retail inflation which considers the monthly change in prices of a certain basket of goods. In India retail inflation rose to 7.6% in October breaching the upper bound of inflation band (2% – 6%) of RBI. The earlier high of inflation was 8.4% in 2014. High inflation is a cause of concern for policy makers. Although agriculture sector showed appreciable performance in Q1 with 3.4% growth while most of the other sectors showed negative growth, the rise in retail inflation is surprising. Food inflation shot up to 11.07% in October; this reflects mainly in high vegetable prices after excess rains destroyed the Kharif crops. Food items such as onions, potatoes, eggs, meat and tomatoes have a nearly 46% weight in India’s retail inflation basket, so the increased prices of vegetables have risen overall retail inflation. Also the increased international prices of edible oils due to falling stocks contributed to inflation as India imports 70% of its edible oil from countries such as Malaysia, Argentina, Indonesia and Ukraine.
High fuel prices also have a major impact on retail inflation. Although the international crude oil prices are low but still retail prices are very high. The cost price of diesel per litre is 27.42 rupees after processing and considering exchange rate, freight charges, refinery cost etc. Central government charges 31.83 rupees per litre tax and after adding dealers’ commission to it the cost price of diesel becomes 61.78 rupees per litre. State government further charges 10.64 rupees per litre VAT after which the final price that consumer pay becomes 72.42 per litre. The taxes by government makes up 58.64% of the final retail price which impacts public hugely. As the demand for oil is inelastic in short run so this makes it an important source of revenue for the government. High oil price are generally thought to increase inflation and reduce economic growth. In terms of inflation, oil prices directly affect the prices of goods made with petroleum products. Oil prices also indirectly affect costs such as transportation and manufacturing. The increase in these costs can in turn affect the prices of a variety of goods and services, as producers may pass production costs on to the consumers. The increased transportation cost due to high diesel price had a major impact on the inflation and thus the food price inflation is high despite the good produce. High food inflation has severe implications, it affects poor population of the country. If it remains high for a significant period of time it could reverse the progress that India has made in lifting the people above poverty line over the last few decades.
High inflation has left less room for central bank to pursue further rate cut to revive demand as it would have to keep inflation in between the targeted band. Low growth rate, high inflation creates a situation known as stagflation wherein an economy experiences a simultaneous increase in inflation and stagnation of economic output.
In Q2 the economy has performed well, even better than the expectations of RBI and there are also some green shoots visible in the economy. All short-term indicators from onwards- electricity consumption, rail freight, auto sales, GST receipts have been rising. As gradually output grows, RBI would get some space to squeeze liquidity from the market and inflation would ease down. In case the retail inflation remains above 6% then both the fiscal and monetary policies will have to act to keep it in check.