Published blog Details

Posted by: Deepa Vasudevan on Fri, Jan 25th, 2019

Low Inflation, New Problem

The next review of monetary policy is due on 7 February 2019, and markets are anticipating a less restrictive monetary regime. At the very least, the monetary stance is expected to change from “calibrated tightening” to “neutral”; and some are even hoping for a small rate cut! This optimism stems from the ridiculously low levels of inflation seen in FY19 so far. During Apr-Dec 2018, average CPI inflation came in at 3.8% and average WPI was at 4.8%.

The main reason for low inflation was subdued food prices, which averaged 0.5% in Apr-Dec 2018. Combine this with moderating fuel prices, and we have a situation of sub-4% headline consumer inflation, a number that is gratifying in a country that is more used to periodic episodes of high food inflation (Pic 1). 

 Pic 1: Headline and Core Inflation

 

Unfortunately, core inflation- inflation stripped of volatile items like food and fuel- remains stubbornly high at 5.5%-6%. A quick look at the non-food, non-fuel components of CPI provides the answer- core inflation has been rising due to a steady rise in health and education inflation (Pic 2). This is not surprising- healthcare inflation has been outpacing general inflation for more than two years now- for reasons ranging from high cost of medical technology, over-prescription of medical services, to an increase in lifestyle-related chronic ailments. Rising cost of education is attributed to strong demand for quality education fuelled by rising incomes, aspirations and loan availability. In fact, the overall uptrend in service inflation, as captured in core inflation, reflects the growing demand for services in both rural and urban areas.

 Pic 2: Inflation: CPI Components

 

This poses a problem for RBI: its monetary anchor (headline CPI inflation) is low, and calls for an easier monetary policy, but high core inflation suggests just the opposite. Why should RBI care about core inflation? Because core inflation, if sustained and prolonged, is almost certain to feed into headline inflation. Studies have shown that headline inflation tends to converge to core inflation over time. In other words, today’s high core inflation may become tomorrow’s high overall inflation!

Thus the Monetary Policy Committee faces conflicting signals when it meets next month. On the one hand, food prices are low, fuel prices appear to have settled down, and the exchange rate is relatively stable. Hope for an investment revival is building up on the back of a steady increase in capacity utilization and a pick-up in bank credit. All these call for monetary easing.  

On the other hand, sticky core inflation and the possibility of fiscal expansion through farm waivers and other pre-election give-aways are likely to put upward pressure on inflation, and stop RBI from cutting rates.  

The RBI may resolve the issue by keeping policy rates constant, while ensuring that the system has adequate liquidity in the traditionally tight fourth quarter; this will give it more time and additional datapoints till the next meeting. Alternately, it may go in for a token rate cut or CRR cut to encourage bank lending. At this point, further tightening does not seem likely. That itself should be good news for markets!

For detailed knowledge on Understanding Monetary Policy subscribe to our course today. You can also check other courses in Macro Economics offered by CIEL.

Post comment

Subscribe to Newsletter

We will never share your email address with anyone and won't bombard you with emails. Refer to our Privacy Policy

Online Courses

Macro Economics
Basic Level
MACRO ECONOMICS MADE EASY

This course gives you a thorough understanding of the key concepts in macro-economics and how to apply them

Macro Economics
Intermediate Level
UNDERSTANDING MONETARY POLICY

Monetary policies are designed to maintain price stability and ensure economic growth. Learn how monetary p

Macro Economics
Advance Level
EXCHANGE RATE AND EXTERNAL SECTOR

Understand how exchange rates fluctuate and the various factors that influence them through this online cou

Macro Economics
Advance Level
GOVERNMENT FINANCES AND FISCAL POLICY

Learn about the different sources of government revenue in economics and the implementation of fiscal polic

Macro Economics
Intermediate Level
MACRO ECONOMICS INDICATORS 1 - OUTPUT AND GROWTH

Learn how to measure economic growth and output through the macroeconomic indicators that influence it.

Macro Economics
Intermediate Level
MACRO ECONOMICS INDICATORS 2 - INFLATION

Learn about the macroeconomic indicators of inflation and their management through this online course.

Contact us

Please learn more about our Privacy Policy