Two steps to control inflation

by Mahesh Vyas

Inflation has risen well beyond the government’s comfort zone and the government has taken two significant steps to rein it in. April 2022 witnessed an inflation rate of 7.8 per cent. This is the highest increase in the consumer price index that India has seen in eight years. It is also much higher than the inflation target of 4 per cent or even the upper 6 per cent limit of toleration set by the government in 2016 and renewed in April 2021 for a period of five years.

The Reserve Bank of India, in recognition of the continued increase in inflation, raised the repo rate by 40 basis points suddenly on May 4, 2022. The RBI raising the policy rate was not entirely surprising but its timing was unexpected. There is some speculation that the move was to protect the rupee which has been depreciating against the US Fed’s scheduled announcement of a rate hike on the same day. The RBI raised the repo rate just a few hours before the Fed’s scheduled rate hike.

Perhaps, more pertinent to inflation control was the RBI’s simultaneous announcement of a 50 basis point increase in the cash reserve ratio maintained by banks. This was raised to 4.5 per cent of net demand and time liabilities effective May 21, 2022. The move would reduce liquidity and possibly help in transmission of the rate changes which, in turn, is expected to rein in inflationary pressures. Average daily surplus liquidity was over Rs.7.5 trillion in April 2022. This fell to below Rs.7 trillion in early May 2022. It will fall further with the CRR changes.

After the September 2019 RBI notification, an increasing proportion of bank lending is getting linked to external benchmarks. Transmission of policy rates is therefore getting better. We now need to see if this would be effective in controlling demand adequately to rein in inflation, or at least core inflation.

Core inflation excludes food and fuels. Prices of food and fuels are influenced by the current global supply problems caused by Russia’s invasion of Ukraine. Interest rate changes are not expected to impact their prices. But, changes in food and fuel prices can impact core inflation also as prices of many products and services are vulnerable to changes in food and fuels. Core accounts for 54 per cent of the overall consumer price index. Implicitly, interest rate changes can at best impact half the constituents of consumer prices. It can do so if the increase in policy interest rates is transmitted adequately and if such a transmission is effective in reining in demand.

In 2022, non-core has been driving inflation. In April 2022, while the overall inflation rate was 7.8 per cent, core inflation was 7 per cent and non-core inflation was 8.7 per cent.

The second step the government took to control prices was in the non-core commodities. On May 14, the government banned the export of wheat. Like the hike in the repo rate, this move too was a surprise. This one was also unexpected. The government was enthusiastic of exporting wheat till a day before the announcement. But, fears of a fall in the domestic crop and possible shortages in supplies seem to have motivated the government to impose the ban.

This is a more direct intervention to control inflation. Wheat has a rather small weight of 2.6 per cent in the overall CPI. In April 2022, wheat and wheat flour prices in the open market (non-PDS) were 9.6 per cent higher than they were a year ago. If wheat prices stop rising, they would still be about 8 per cent higher than the year-ago levels.

Bakery bread prices were 9 per cent higher y-o-y in April. Prices of bajra and maize are much higher, at 21 and 13 per cent, respectively in April. But they have low weights in the CPI. Inflation in rice, a heavyweight with a 4.4 per cent share in the CPI, was benign at 3.9 per cent.

The problem in food inflation is not as much in cereals which collectively pencilled an inflation of 6 per cent in April against an overall inflation was 7.8 per cent. It is oils and fats with a weight of 3.6 per cent that leads the damage as it reported an inflation of 17.3 per cent in April. India imports edible oils and the major exporter, Indonesia, has banned exports of palm oil from 20 April 2022.

The other two sources of inflation in the food index are vegetables and spices. Vegetables has a weight of 6 per cent and spices has a weight of 2.5 per cent. Inflation in these two groups was 15.4 per cent and 10.6 per cent, respectively in April 2022. Their influence on the overall CPI is much larger than that of wheat.

The government has refrained from intervening in the fuels & lights segment that saw an inflation of 10.8 per cent in April 2022. The price of the Indian basket of crude oil declined by a substantial 9.5 per cent in April 2022 to USD 102.9 per barrel from USD 113.7 per barrel in March 2022. But, the consumer price index for fuel and light rose by 3.1 per cent at the same time. During the month, LPG prices rose by 4 per cent, kerosene (PDS) by 20 per cent and diesel by 10 per cent.

The two steps taken to control inflation may not make a material difference to inflation in the short run. Policy interest rate changes would take time to impact inflation and the wheat ban would make an insignificant impact on the CPI.