New Governor at RBI Inherits the Same Old Inflation Worries

At the end of the week, Raghuram Rajan will hand over the title of Governor of the Reserve Bank of India to current Deputy Governor Urjit Patel. With that title will come the responsibility of bringing consumer price inflation down to 5 percent by the end of this financial year.

In its annual report for the year-ended June 30, the RBI said consumer price inflation is expected to trend towards the target of 5 percent, but only in the last quarter of the financial year. At this juncture, though, upside risks are prominent, according to the central bank.

Driven primarily by a sharper-than-anticipated rise in food inflation, consumer price inflation spiked in the first quarter. In July, it hit a 23-month high of 6.07 percent.

But the RBI is fairly confident that the spike in food inflation will be short-lived.

But the worry is that non-food inflation will rise. “If the current softness in crude prices proves to be transient and as the output gap continues to close, inflation excluding food and fuel may likely trend upwards and counterbalance the benefit of expected easing of food inflation,” the central bank said, reiterating the stance it took at its monetary policy review earlier this month.

Another complication is likely to arise from the payout of the seventh pay commission’s recommendations.

The RBI expects that the largest effects of the implementation of the pay panel’s recommendations will emanate from higher house rent allowance in the consumer price inflation. This is likely to raise headline inflation in a purely statistical manner, said the RBI.

“In addition, the indirect effects through demand and expectations channels could add to the headline CPI’s path,” it added.

The impact of the pay commission is likely to peak by September 2017. The RBI expects that in the interim, attempting to separate the statistical effects from those that cause “durable” inflation, will complicate monetary policy formulation.

Impact of Monetary Policy on Inflation

The RBI conducted a study to map the impact of monetary policy actions, specifically, the changes made to the policy rate, on consumer price inflation.

The results, published in the annual report, show that one-fourth of the decline in inflation during April 2014 and December 2015 was on account of the policy rate changes.

After Rajan took over in September 2013, he raised policy rates by 75 basis points to 8 percent and then retained it at that level for almost a year. Then, between December 2014 and December 2015, the repo rate was cut by 125 basis points.

The study also found that a large reduction in consumer prices was on account of the reduction in food prices, a direct result of the central government’s supply management policies.

A slowdown in rural wage growth and the decline in global crude oil prices were other facilitating factors.

Also Read: Raghuram Rajan, En-Route to Exit, Outlines RBI’s ‘Work in Progress’