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April 30, 2017

Indian Economy: Pricking the inflation balloon

The Reserve Bank of India (RBI) has succeeded in restraining inflation in the comfort zone over the past four years. As a result, consumer price index-linked (CPI) inflation averaged 4.6% in the first 11 months of this fiscal. Inflation declined sharply following demonetization. But this has failed to satisfy the RBI. Not only did it stay pat on rates in its February monetary policy review meeting, but it also changed the policy guidance to 'neutral' from 'accommodative'. In February, CPI inflation rose to 3.7% on the back of higher food and fuel inflation, while core inflation stayed sticky around 5%, further deepening RBI's concerns.

We estimate inflation will rise to 5% on average in fiscal 2018. While this is still within the (4 ± 2)% range set by the government, it is higher than the 4% central value that the RBI is targeting over the medium run. Inflation could very well rise as there is an expected upside from fuel inflation even as core inflation remains stubborn despite weak domestic demand/excess capacity.Typically, the most straightforward policy approach to lower inflation is to adopt a tighter monetary policy supplemented by a tight fiscal policy, which calls for fiscal-monetary coordination. Such coordination is lacking in some ways.

Since 2015, the monetary policy has been easing (repo rate was cut by 175 basis points or bps), while the fiscal policy was tightening (fiscal deficit was reduced from over 4% of GDP in fiscal 2014 to 3.5% this fiscal). Close coordination between fiscal and monetary policy is critical to maintaining financial stability, the absence of which can lead to higher-than-desired interest rates, pressures on exchange rates, and rising inflation, all of which can impact growth and the effectiveness of the policies.

Thus, we believe the monetary-fiscal policy mix will have to adjust such that both become tighter to control inflation. But the fiscal policy will have to assume a bigger role – consolidation will have to be accompanied by a significant reorientation of spending towards agriculture, health, education, and infrastructure where supply constraints are worrying and are the real reason for stubborn inflation. A tighter monetary policy will not be able to hold back demand for long in these sectors.