When the Reserve Bank of India adopted a formal retail inflation target and turned into an inflation-targeting central bank just like its developed economy peers, little did it anticipate a potential failure only six years into the job. To be fair, pretty much every inflation-targeting central bank globally is staring at an embarrassing failure this year and some have even tasted it already.
The RBI is mandated by law to keep retail inflation in a 2-6 percent band and it will fail to do so if retail inflation averages above 6 percent for three consecutive quarters. The odds of this happening are high after the inflation print of 6.7 percent for July.
Most private economists have pegged their forecasts at around that of the RBI or slightly below. But none expects Consumer Price Index inflation to slip below the 6 percent mark.
FY24 could be a lot more forgiving on the inflation front as the base effect itself could bring down progressive readings. Economists expect average inflation to be about 5 percent for the next year.
While that would bring inflation within the mandated band, in spirit the RBI would consider a win only when the coveted 4 percent medium-term target is reached. Economists expect it will take another six quarters at least for headline retail inflation to drop to 4 percent.
Global commodity inflation would continue to weigh heavily but fiscal policy, and the strength and unevenness of economic recovery would be determinants of inflation as well, making the journey to 4 percent arduous for the RBI.
Push becomes shove
Some factors that have capped the surge in inflation are from the fiscal side. Whether it was the restriction of imports of important food grains or a cut in taxes on fuel, the government has done its bit to keep retail prices from rising unbridled in the wake of the global surge in them.
Rahul Bajoria, chief India economist at Barclays, pointed out that a lot of what the RBI can do depends on how much the government reverses its fiscal policy measures.
“There are a lot of fiscal tools at play in managing inflation. Some of these tools may have to be reversed,” he said.
The government plans to bring most goods under the ambit of the goods and services tax. GST has been increased for several items, which may feed into inflation as manufacturers hike market prices to absorb the tax impact. Then there is the government’s fiscal deficit itself, which needs to be brought down.
Bad side of good news
India’s economic recovery has gained traction, in a relief to policymakers. Under the pleasing recovery is weak consumption demand, which prevents demand-led inflation.
However, this has to be seen through the lens of pricing power. Companies have been able to increase prices and prevent a sharp erosion of their profit margins despite weak consumption demand.
The uneven K-shaped economic recovery has meant that large listed manufacturers dominate the pricing decisions of items while the universe of small businesses buckles under pressure.
“The companies that are big and dominate industry also supply much of the consumption goods and services while a large part of small business are involved as suppliers to big companies. So a few large companies determine the pricing of goods and they can easily hike prices,” said an economist at foreign bank, requesting anonymity.
The upshot is that even if consumption demand isn’t as robust as it was before the pandemic, there is no guarantee that prices will come down. Eventually, demand for higher wages will feed into inflation.
That brings us to inflation expectations, something the RBI must monitor at all times. Household inflation expectations have cooled off in recent months, but they remain elevated. Confidence that prices may come down is shaky yet. Until expectations show a sustained drop, the outlook on retail inflation is likely to remain clouded.