If India needed another reminder on the need to reduce its import dependence in key sectors, it has one now. This is not an argument for protectionism.
The Covid-19 pandemic has challenged health professionals to the extreme. It has also proved to be confounding for economists. The recent spurt in inflation isn’t out of the textbook. The massive slump in demand in the aftermath of the pandemic destroyed economic growth. It ought to have killed inflation as well. However, in what is particularly troublesome for governments and policymakers, inflation has reared its head in advance of any firm revival in demand, adding one more challenge to an already difficult economic scenario.
There are some additional peculiarities in the nature of the current bout of inflation. In India, the Consumer Price Index (CPI) usually trends higher than the Wholesale Price Index (WPI). In this cycle, the WPI is at almost double the level of CPI, hovering at over 12% as compared to just over 6% for CPI. It may seem counter-intuitive because a faster rise in prices at the wholesale level ought to transfer to the end consumers. But it is more likely to be linked to the different weightages accorded to different goods and services in the two indices. Fuel and manufactured goods have a higher weightage in WPI than in CPI, which in turn accords greater weightage to food and services. The price rise is concentrated in the former, not the latter.
Indeed, this fits in with a peculiar global trend recently highlighted by IMF Chief Economist Gita Gopinath. Inflation across countries seems to be concentrated in goods and the excess of goods inflation over services inflation is unusually high in this cycle compared to longer term trends.
What is clear is that this is not an inflation fuelled by excess demand. Therefore, the standard textbook policy response of hiking interest rates should not be applied in a kneejerk manner. So far, RBI is sanguine and has retained an accommodative monetary policy stance even while keeping rates on hold. That it has done so despite the CPI crossing 6% is admirable. The Monetary Policy Framework mandated by legislation requires RBI to target a CPI of 4%, with a plus or minus 2% band. Currently, the rate of inflation is outside the target zone.
What will complicate the scenario for RBI is the setting of inflationary expectations. Econ 101 tells us that what really determines inflation is the future expectation of economic agents, and not the current level. Unusually, core inflation, which is CPI minus food and fuel, is also rising in India, which may suggest a firming of expectations. In the past, when bouts of high CPI inflation have been caused by spikes in food prices and fuel prices, core inflation has remained low. At any rate, one must hope RBI holds it nerve until there is a stronger revival in demand. With the possibility of a third wave of Covid not ruled out, it is impossible to say if the current growth momentum will last. The second wave badly interrupted the momentum gained after the ebbing of the first wave.
A more disaggregated look at where the inflationary pressure is coming from is revealing. Needless to say, high global fuel prices are a primary cause. This has been the case in the past as well. A second pressure point comes from the edible oil segments. A third pressure point comes from commodities, mostly metals. What is common to all three categories is a high import dependence and acute vulnerability to changes in global prices.
The prices of commodities have been rising globally for reasons that have nothing to do with India and its policies. Loose monetary policies in the advanced economies, particularly the US, have created pitiful cheap liquidity looking for investment avenues. Commodities are one asset class into which this liquidity has poured in (equities being another). However, the rise in commodity prices isn’t only driven by cheap liquidity. There is also an underlying growth in demand for commodities primarily because China, the second largest economy in the world, recovered very quickly from the Covid-19 slowdown. With the US now opening most of its economy following a successful vaccination drive, demand for commodities will rise further.
If India needed another reminder on the need to reduce its import dependence in key sectors, it has one now. This is not an argument for protectionism. It is a strategic compulsion for greater stability in the macroeconomy, without which there cannot be an enabling environment for growth. India needs to double down on increasing domestic production of oil and related products as well as increase its exploration of key minerals, including lithium and cobalt, which will become increasingly important in the future. To do that, it must stop looking at these sectors merely as handsome contributors to the exchequer. The revenue burden must come down to favour higher production.
Along with new conundrums, Covid-19 has reiterated some old truths. India has to act.
Dhiraj Nayyar is Chief Economist, Vedanta. Gouranga Sen, Senior Business Analyst, Vedanta, contributed inputs to this article.