India’s retail inflation has stayed persistently elevated since 2009-10 due to a combination of structural and cyclical issues. The problem has continued at full vigour despite the central bank’s consistent anti-inflationary stance. While the Reserve Bank of India (RBI) has been fighting its war against inflation by keeping monetary policy on a tight leash, the higher governmental spending on subsidies and administered prices of nearly 30 per cent of agricultural commodities kept on fuelling retail inflation during 2009-2014. Furthermore, the government’s higher revenue deficit has raised the cost of credit and crowded out private investment, which, in turn, has worsened the supply side capabilities. The recent data-points on factory output growth (at -0.1 per cent in FY14) and retail inflation (at 8.59 per cent in April) clearly show the nation is pushed into a more or less stagflationary mode. The lack of coordination between the monetary and fiscal policies is to be blamed for this mess.
The recent election outcome, however, has revived hopes as a single political party has won the largest majority in almost 30 years, implying a stable government that can conduct policies with no impediments from diverging coalition partners. Based on the election manifesto of the ruling party, it may be fairly concluded that the new government appears to be committed to address structural issues behind food inflation, which is the stickiest part of the overall inflation. Sources state the new government will try to bring down food inflation by raising supply through better management of food grain stocks, imports etc. and by cutting wastages. There are also plans to spur growth through huge public investments in infrastructure, which will go a long way in improving the potential output growth.
If the new government achieves fiscal consolidation by lowering revenue spending and increasing capital spending, then monetary policy will be more effective in controlling inflation.
However, real sector adjustments take time and we do not expect sudden improvement on inflation front. We expect retail inflation to stay in the band of 8-8.5 per cent during 2014-15. Also, the El Nino effect on agriculture and global commodity prices continue to pose key risks to inflation in 2014-15.
Even if inflation remains way above RBI’s comfort zone, in our view, the growing real sector weaknesses will force RBI to take a prolonged pause on interest rates through 2014. However, a likely fall in inflation in 2015 may open up space for monetary easing next year.
The writer is chief economist at Bank of Baroda