How will the economy respond when the RBI when reduces rates further in the coming months? If the inflation does not go up, it will provide substance to RBI’s view. Till that time it is more of wait and watch

The “New Normal Inflation” debate has been reignited by the RBI (Reserve Bank of India) governor Duvvuri Subbarao. In a speech made to bankers recently in New Delhi, he opined that it would be unfair to assume that new normal inflation is here to stay in India. The critics of this approach followed by RBI in tightening monetary policy have often argued that the time has come to reconcile with the new rate of inflation that is going to stay and will be higher than the rate of inflation, which existed during pre-2008 crisis era. It is pertinent to note that “new normal inflation” is a term being used in context of high rate of inflation prevailing in the Indian economy post 2009. The new normal inflation assumes a rate of inflation in the range of 8% to 10%. The rate of inflation had surged significantly before it started falling in third quarter of 2012-13. The rate of inflation prevailing in India post 2000 has been as follows:

The RBI governor believes that the central bank is committed to bringing down inflation below the current levels and in the long run bring it down to 3%-4% levels. The speech of RBI governor minutely examines both arguments in favour of new normal inflation and the arguments formulated by RBI against it. Let us look at some of the factors that have caused inflation in India post 2009-10.
 

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Surging commodity prices, particularly fuel prices:  There has been an increase in the prices of various commodities world over. For India, the increase in crude oil price has been one of the villains in fuelling inflation rate. The average price of India’s crude basket has gone up as follows post 2000-01:
 

Those who believe that crude will play a spoilsport in taming inflation in India believe that crude prices may just go up because of the actual demand which is anyway going to surge as the population of the world goes up and demand for crude increases.  However, the real threat to commodity prices may come from, “financialisation of commodities” which will drive commodity prices as global liquidity arising from quantitative easing may chase commodities for better returns.
 

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Wage rate increases: Those who believe that in the days to come we may have to continue with this new rate of inflation prevailing in the economy also argue that increasing wage rates across industries, including rural wages, will be a key challenge in containing inflation. There has been a significant surge in the wage rates across country over a period of time.  A series of affirmative action initiated by the governments both at central and state levels have pushed up the rural wage rate, which has added to the inflation numbers. In some states wages rural wage have gone up by more than 150% during last eight years.
 

Supply-side constraints will hit world economy and imports will become costly: The supporters of new normal inflation believe that the China factor will be a key in determining global inflation in the days to come. This argument comes from the fact that China was a major supply source for the world in the pre-crisis era and this benefited the entire world in terms of managing lower inflation. The speech given by the RBI Governor highlights the fact by mentioning “The world enjoyed an extended period of extraordinary price stability during the Great Moderation of the pre-crisis years. As we now know, this was largely the benign influence of the integration of emerging economies, especially China, into the global economy. Through the 80sand 90s, China alone added over a billion people to the global labour pool. This raised global production, but without commensurate increase in demand, and hence prices remained low”.  There is a fear that the era of cheap imports may be over now and this may fuel inflation across world, including India.
 

Apart from these three obvious factors, issues such as integration of the Indian economy with the global economy, quantitative easing in various countries, etc have fuelled the inflation in India. These factors combined together have resulted in this new normal inflation.
 

Is the new normal inflation here to stay? Now the most important question is—is the new normal inflation here to stay? The answer is a firm ‘No’ as per RBI. One of the most interesting arguments given by the RBI gets reflected in the optimism of softening of commodity prices. The RBI document says, “From the supply perspective, the shale revolution, first for gas and then for oil, is expected to contribute almost a fifth of the increase in global energy supply by 2030. A roughly similar positive contribution is likely from renewable sources of energy—expected to treble by 2030. Growing domestic production and near flat consumption may see the US become self-sufficient in energy by 2030. Supply from Iraq is projected to increase steadily, and by 2030 it is likely to become the second largest global oil exporter, overtaking Russia”.
 

The RBI is also optimistic that wage price spiral cannot continue in the long run. Two other arguments given by the central bank in support of softening of inflation in the years to come are that due to global rebalancing inflation rates will get reduced in the years to come and also quantitative easing may not act as the real threat.
 

As usual, the RBI document is focused on the demand side of management of inflation. In fact, that is what the RBI can do as a monetary authority. However, practically inflation in India has often been fuelled by supply-side constraints. Food inflation is an example of it.  Failure of crops because of failure of the monsoon has caused inflation on multiple occasions. Apart from production, supply chain management of foodgrain has also acted as the villain on many occasions.
 

Populist policies followed by the government have been a key driver of demand in India and this will continue till the time there is a thirst for power. So the RBI has very limited control on this. Increasing rural prosperity continues to be a challenge for managing inflation in India. Also, the RBI will have limited say in controlling fiscal deficit. All these factors combined together give an impression that we have cope with inflation for some more time. More important than that, it will be pertinent to observe how the economy responds to softening of interest rates by the RBI when it reduces rates in the coming months. If the inflation does not go up, it will provide substance to RBI’s view. Till that time it is more of wait and watch.
 

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(Vivek Sharma has worked for 17 years in the stock market, debt market and banking. He is a post graduate in Economics and MBA in Finance. He writes on personal finance and economics and is invited as an expert on personal finance shows.)