The biggest concern today is inflation for both the government and RBI. This is because at the current rate of above 7%, the chances of it going to the sub-6% level, which is the upper limit of tolerance of the RBI, looks a bit difficult this year. How exactly have we reached this situation considering that in the February policy the RBI had projected a sub-5% inflation rate for FY23 which was revised upwards in April to 5.7%, which also probably will be revised again this time?
The issue really is the war which has sent commodity prices northwards. It started with crude oil where Russia is a major supplier in the global market. With sanctions being imposed it was but natural that the payments system got disrupted leading to their supplies being removed from the system. Oil was still outside the purview of the sanctions, but there was a contagion that went into the other energy pockets. Russia is a big player in natural gas and coal. With these products also being under the embargo, prices started increasing as supplies dwindled. Next in line was fertilisers where the prices started going up given that natural gas is the main ingredient here. The spread of inflation entered the metals sector too where Russia has some presence in iron ore. Therefore, inflation from outside permeated the domestic corridors.
However, the contagion did not stop at just these energy and metal products as the food segment also got affected. Russia and Ukraine together are major suppliers of wheat as well as sunflower oil. With supplies being cut due to disruptions in the case of Ukraine, where the infrastructure has been destroyed and Russia due to sanctions, their supplies are not moving out of their geographies.
This has meant an acute shortage of wheat and edible oils which has led to prices moving up quite sharply. The wheat problem in India has been exacerbated by the fact that production is lower than expected with the heatwave affecting the crop. The opening up of export opportunities has caused wheat to be diverted to this market and over 10 mn tonnes have been exported which has led the government to impose a ban on exports.
A similar situation has arisen in the edible oil market. With sunflower oil being out of the reckoning, where India is the largest importer, demand for other edible oils has increased including palm oil. This has had a ratchet effect on prices of all traded oils going up as countries substitute other oils for sunflower. Indonesia, being one of the largest suppliers of palm oil, imposed a ban which is now being rolled back. But prices have increased sharply.
Inflation in India was already getting broad-based with almost all commodities witnessing an increase in prices. Manufacturers of several goods such as FMCG, food products, household goods etc. have started passing on higher input costs to the consumer in Q3 and Q4 of FY22.
With raw material prices going up again, there is an imminent threat of a second round of inflation. Consumers must have already realised that their toothpaste, shaving cream, biscuits, bread etc. have become more expensive or reduced in size if prices have not changed. This inflation was already in place when the war struck. With the war's impact catching on, one can see that prices of almost all products have gone up. Even services like health care, education, and recreation have become more expensive as companies have increased prices to make up for the losses suffered during the pandemic.
With such broad-based inflation, what can the government do? The centre has taken some progressive steps in lowering the excise duty on fuel products and reducing the price of LPG cylinders. This has been supplemented with the removal of cess on imported edible oil with some other reduction in duties on steel products. This will help a good measure in controlling inflation. But will it help to lower the inflation rate to 5%? The answer is probably not so soon. There has to also be monetary policy action.
This is probably the thought behind the RBI increasing the repo rate between policies in May with the guidance being given in the minutes of the meeting that it was not desirable to have a big increase in repo rate at one shot but phased it over time. Hence the 40 bps increase in May will be followed up with another 25-35 bps increase in June and further during the year until we reach a rate of 5.15%. The 5.15% rate has become significant today because this was the rate at the time of the pandemic from whence the RBI lowered the rate to 4%. Hence it does look like the interest rates are now going to be on the upward bend of the curve.
Is this necessary? Yes, if inflation is not curbed it will affect growth. As inflation eats into the purchasing power of households, they will have less money to spend on discretionary goods and services which in turn will affect GDP growth. Higher rates is not good news for home buyers as EMIs get elongated, but savers may heave a sigh of relief as they have been getting negative returns on savings, which can gradually turn positive provided the RBI continues increasing rates and banks follow suit.
(The author is Chief Economist, Bank of Baroda, and author of Lockdown or Economic Destruction. Views expressed are personal)
