Most major economies found themselves struggling to contain domestic prices of key commodities, thereby further widening the demand-supply imbalances.
In fact, global inflation has been surging since 2021. It has become a major concern for policymakers across the economies.
The economic consequences, visible in the commodity market, trade, and financial linkages are retarding growth and escalating inflation further, a report by ICRIER showed.
Consequently, the obvious next step was for central banks of each economy to focus on monetary tightening. Key policy rates were hiked back to their pre-Covid levels to absorb excess liquidity.
As a result, India — like other emerging and developing economies — also experienced persistent inflationary pressures since the beginning of financial year 2022. And, the next step for Reserve Bank of India (RBI) was to raise benchmark lending rates by 140 bps in 4 months.
However, inflation numbers for the month of August surged to 7% yet again after showing a downward trend since last 3 months. This has raised speculations that RBI’s inflation mandate is about to fail.
The RBI is deemed to have failed when average inflation is outside the 2-6% tolerance range for 3 consecutive quarters. For fourth quarter of the previous financial year 2022, inflation averaged at 6.3%. It surged 7.3% in April-June 2022 quarter (first quarter of FY23). Now, inflation must fall to at least 4.1% in September for the July-September average to come in under 6% and the RBI to avoid failure. This seems to be an unlikely scenario.
According to RBI’s latest forecast, inflation will average 7.1% in July-September.
Who stands where
The ICRIER report said that inflation has remained higher than previous forecasts, in both developed as well as underdeveloped nations.
Inflation numbers for Turkey was recorded at 80.2% and for euro area it is 9.1% (for August 2022), whereas inflation for Brazil, UK and USA stood at 10.1%, 10.1% and 8.5% respectively (as of July 2022).
Nevertheless, Asian countries like Japan, China, and Vietnam registered retail inflation within the range of 2-3% year-on-year (y-o-y). However, given Japan’s history of disinflation, even its current 2.6% inflation is at its highest level since October 2014.
Comparatively, RBI has projected India’s inflation to be 6.7% in FY23. In other words, inflation situation in India is elevated but still within control.
What led to the surge
At first, worldwide lockdowns and restrictions on mobility in a bid to curb the spread of Covid-19 had detrimental impact on all economies. ICRIER report noted that with a halt in business activities, wages and income level declined which in turn led to a fall in aggregate demand.
To revive this, governments across countries opted for expansionary fiscal measures like giving guarantees, grants, tax reliefs, tax deferrals and the likes.
The report added that globally an aggregate of $16.9 billion was undertaken to restore the losses incurred by all economies. These were accompanied by a cut in policy rates by all major central banks.
However, even though the measures were beneficial for the poorer sections of the society, it created excess of liquidity in the system or there was ‘too much money chasing too few goods’, which in turn pushed up prices. Hence, these expansionary policies which were adopted to spur up economic growth, actually led to wider fiscal deficits.
Things became worse when Russia invaded Ukraine in February 2022, closing several major trade routes. Both Russian and Ukraine held a significant share in world production and export of various agricultural commodities namely wheat, corn, barley, sunflower seeds, and sunflower oil as well as fossil fuels such as oil and natural gas and fertilizers. This pushed up global prices of key commodities like Brent crude oil to record highs.
Moreover, economic sanctions imposed by EU and USA on Russia, and elevated production costs due to decarbonization have further added to the price rise, the report said.
Inflation and growth
Consumer prices hit record highs for almost all major economies and they were compelled to opt for policy rate cuts to help their respective regions.
Rate cuts had become the need of the hour for almost all economies. For instance, US Fed increased policy rates by 200 basis points (bps) since April this year and is likely to increase more in the coming months. Likewise, the European (Central Bank) (ECB) raised interest rates by 50 bps and hinted about more hikes to bring back inflation to 2% of the target level.
The report said: “Hikes in interest rates in these advanced countries are making other emerging markets less attractive to foreign investors, resulting in the increase of outflows from) their bond and equity market.”
Why food inflation is a worry
It is well known now that almost 70% of the spillover effects of a war between two of world’s largest producers has impacted people’s household budgets.
A look at the chart below clearly indicates that overall food inflation has been the main cause of surge in inflation in India. In fact, food index has been rising rapidly since October last year, much before the beginning of Russia-Ukraine war.
Breaking down the overall food inflation further, we can the price of spices surged the most on an annualised basis. Vegetables, fuel & light also surged beyond 10%.
In case of oils and fats, inflation is largely imported, as the country’s 55-60% of the edible oil demand is met through imports. The price hike in edible oil due to geopolitical tension and resultant supply disruptions, and the impulsive export ban on crude palm oil by Indonesia (which was lifted later on) transmitted to domestic edible oil prices which recorded inflation of 18.8% (oil and fats y-o-y) in March 2022.
The report clarified that food and beverages constitute 45.9% of the CPI basket and within that, the consumer food price index (CFPI) constitutes 39.06%.
But, this is in contrast to may advanced economies who have a lesser share of food weight in their inflation basket. For example, UK (9.3%), US (13.2%), Canada (15.94%) and Germany (8.5%).
How food inflation affects RBI’s policy
Reserve Bank’s monetary policy committee has been mandated by the Centre to keep inflation rate within its tolerance band of 2-4%, +/-2%.
RBI has already recognised that inflation will remain above the upper tolerance level and therefore, revised the projected headline inflation upwards from 4.5% in February to 6.7% in August 2022.
Now, when food prices comprise the majority of your consumption basket, it is difficult to make price movement predictions. Food price index is susceptible to cost fluctuations, both on account of seasonal factors and policies introduced by the Centre. Hence, volatile prices have an adverse impact on policy decisions by RBI. It in a way curtails their policy choices.
This is why the ICRIER report calls for an urgent revision in CPI with latest consumption survey weights. It is of the opinion that higher the weightage of food in overall CPI, the more cumbersome it is for monetary policy to contain inflation, as is the case in India.
Will CPI basket revision help?
According to market experts, a reduction in food items from overall consumption basket might make things comparatively easy for RBI.
It will be easy for the central bank to make accurate projections and adopt relevant measures for contingencies.
Since the CPI basket will no longer be at the mercy of price fluctuations, RBI can opt for more precise policy decisions.
However, Centre’s ban on rice, wheat exports may offset supply shortages and check prices. Even though fall in global crude oil prices may come to India’s advantage, surging rates of milk domestically may be a cause of concern.
What needs to be done
The ICRIER report said that short-term policy measures may not be enough to contain food inflation. Therefore, it suggested a few measures that might prove beneficial. Apart from revision in composition of consumption basket, it suggested that economies focus on fiscal consolidation to tame inflation rather than just sticking to monetary tightening.
India’s fiscal deficit has surged to 14% (both Centre and state) in FY21, mainly on account of relief measures announced by the Centre in wake of Covid-19 pandemic. It expects the fiscal deficit to be 6.4% of GDP for FY23, but the report said that it is unlikely this target will be maintained unless taxes and other revenues improve. Hence, it suggests developing a roadmap for fiscal consolidation.
Another measure suggested by ICRIER was liberalising trade policy across economies. When the war struck, most of the economies in the West rushed to impose sanctions on Russia, displaying their protectionist side. However, the report calls for adopting a prudent policy to liberalise trade policy across economies in a bid to curb global price surge.
It cited restrictions like Russia’s export ban on wheat, Indonesia’s ban on palm oil exports (which was later lifted), Argentina’s ban on beef export as well as Turkey, Kyrgyzstan, Kazakhstan, and India’s ban on a variety of grain products. It was further noted that all such restrictions added to global inflationary pressures as sudden spike in prices also led to supply shocks.
“Rather than an outright export ban, a better solution would be to filter exports through a gradual process of minimum export prices and transparent export duties for short durations in India. Additionally, rationalising the import regime through a reduction in tariffs and duties across the board is crucial,” the report said.