Why GST may stoke inflation in the short-run
However, a rise in prices would be a transitory one.
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Inflation and repo rate are linked logically in a direct proportion. If inflation slows or falls, repo rate should fall too.
Monsoons have been poor in the past. Despite that, inflation did not run into double digits, except in 2000. The monsoons, however, has been good this year so far.
The government has taken certain positive steps like increasing the acreage of food crops, building storage reserves for foodgrains and better marketing facilities for the farmers.
With all preparations in place and a good monsoon, we should have bountiful produce, and consequently, food prices must fall.
In 2000, double-digit food inflation had an impact on inflation expectation also. The rise in rural wages consequent upon government expenditure had added its might. Persisting inflation was due to the resultant increase in food demand, aggravated by supply-side bottlenecks.
But this time, we are better prepared for the monsoon by the way of storage, some improvement on the supply-side and no sudden uptick of rural wages. In fact, some select items of food like vegetables and pulses are seeing double-digit growth in prices which may be temporary which is not going to affect inflation expectations in any way.The policy-makers have to respond to demand shocks.
Food inflation is under control and therefore this time retail inflation (CPI) is not likely to be high and persistent. Even if the inflation target of five per cent is breached, the RBI will still remain safely with the inflation target fixed by MPC at four per cent (+) or (-) two per cent. However, inflation expectation which is a new sentiment, like the sentiments of the stock market, has the potential to affect prices adversely.
Inflation targeting does not mean only raising rates. If inflation is falling, the repo rate needs to fall. And if you don't reduce the rate if inflation falls, it hurts inflation targeting itself. So rates are dependent on inflation. Inflation targeting also needs positive communication from the Mint Street to keep the inflation expectations at bay.
If the prime role of inflation targeting is to anchor household inflation expectations, then the headline CPI basket needs a close scrutiny. That is why it is useful to target the headline CPI. But it is true that the headline has a lot of components that are not affected by aggregate demand.
Headline inflation is a measure of the total inflation within an economy. It takes into account food and energy (that is oil and gas) prices which tend to be more volatile and prone to inflationary spikes. On the other hand, core inflation (also non-food manufacturing or underlying inflation) is calculated from a price index minus the volatile food and energy components. Headline inflation may not present an accurate picture of an economy's inflationary trend since section-specific inflationary spikes are unlikely to persist.
The interaction between the demand and the supply side, between the RBI and the government is very important to achieve the medium-term target of four per cent. If prices of some critical commodities like oil, food, pulses, milk are brought down, in which the government has an important role to play, the target is achievable.
In India, we have a lot of excess capacity; export growth has been falling, which means we are facing a demand shock from abroad. The neutral rate is affected by temporary shocks. Negative demand shocks reduce it.
The policy-makers have to respond to demand shocks. Since domestic demand is also low, the policy needs to compensate for that in order to stabilise output. It suggests demand is the real constraint. Firms will not invest if they don't see movement in sales.
There is a concern that Goods and Services Tax (GST), which is expected to come into effect from mid-2017, will stoke inflation at least in the short-run. If it is a temporary blip, then there is no need to worry.
Any rise would only be a transitory one. In case it coincides with falling food prices, and oil prices remain soft so that headline inflation stays well within the target band of four per cent-plus or minus two per cent, it would not be an issue.
The payouts following the implementation of the Seventh Pay Commission recommendations should help revive consumer demand and direct foreign investment can also be a true driver of economic growth.