Our response to inflation should go well beyond monetary policy

After showing signs of moderation in July, India’s inflation estimates for August have again moved upwards. While overall inflation measured by the consumer price index (CPI) was 7%, wholesale price index (WPI)-based inflation remained above 10% for the 17th month. In both, it was food inflation driven, with inflation in cereals in double digits. For the CPI, among the three major cereals, rice inflation was 7% compared to a negative reading the same month last year. But the other two major cereals of wheat and maize recorded inflation at more than 10%. In the case of WPI, wheat inflation was 17.4%, the highest since at least 2012, and for maize it was at 25.3%. These confirm fears that our inflation pressures aren’t transitory and are likely to persist longer than expected.

Since the inflation rise in India is not isolated but part of a broader upward trend seen in most developed and some emerging economies, the approach to dealing with it has been similar, with monetary policy playing the central role. However, such an approach is unlikely to be of any help in the Indian case, primarily because of the nature of inflation, which although driven by international fuel and food prices is inherently different. First, unlike developed countries, which gave large fiscal stimulus during the pandemic, India’s response was muted. Much of the fiscal stimulus was not in term of direct income support but by way of credit support and distribution of food, particularly through the Pradhan Mantri Garib Kalyan Ann Yojana (PMGKAY) that provided 5kg of free foodgrains to individuals. Second, while in developed countries (particularly the US) inflation has been accompanied by a rise in wages to confirm a wage-price spiral, India’s job situation is the opposite, with wages showing negative growth. India presents a special case of declining wages and rising inflation. While this will clearly increase rural distress, it also implies that monetary policy may prove ineffective. Third, unlike developed countries, India was already witnessing a sharp slowdown in economic growth driven by declining demand. In such demand-constrained conditions, excessive reliance on monetary tightening is unlikely to be of much help and may instead end up hurting growth more.

National income estimates released last month confirm these fears, with growth estimated to be lower than the government and Reserve Bank of India’s projections. Fourth, inflation in India, at least in recent months, has largely been driven by food prices, particularly cereals. Given the large weight of food in the consumption basket, monetary policy will have little impact on food inflation. While the usual explanations of the current spell of inflation being driven largely by international factors are true, our domestic supply of major cereals is also responsible. After wheat output falling short of its projection, there are now indications of a decline in rice production, likely by 10-12 million tonnes compared to last year. Rising rice prices suggest that it may not be long before rice inflation also hits a double-digit rate.

Therefore, reliance on monetary policy alone to control inflation is likely to have only a limited impact. Instead, it may threaten the nascent economic recovery after the pandemic. Amid such a growth-inflation trade-off, the prudent option would be to prioritize our economic recovery rather than sacrifice economic growth without much effect on inflation. This needs a proactive fiscal policy that avoids expenditure reduction measures but increases spending to protect citizens from the negative effects of inflation. Since inflation erodes the purchasing power of consumers, fiscal policy can play an important role in increasing incomes and protecting demand. While income generating programmes, such as rural infrastructure creation, along with higher spending on the National Rural Employment Guarantee Scheme will contribute to raising incomes, extending the soon-to-end PMGKAY would not only cool food prices, particularly cereals, but also increase the disposable income of most beneficiaries.

The peculiar nature of inflation currently requires a proactive fiscal approach rather than relying on monetary policy as the main instrument of inflation control. The policy priority must shift to protecting India’s people from a further squeeze in incomes and boosting incomes in people’s hands. This may not control inflation in the short run, but will surely revive growth, which is a bigger worry right now, given India’s slowdown and muted recovery from the covid pandemic.

Himanshu is associate professor at Jawaharlal Nehru University and visiting fellow at the Centre de Sciences Humaines, New Delhi

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