The inflation target of India, instituted by the Reserve Bank of India (RBI) and the Indian government, is 4% consumer price index (CPI) change within a band of 2 – 6%. For the last quarter of the fiscal year 2016-2017 – the quarter from January 2017 – March 2017, the RBI is expecting to contain inflation to 5% and in the medium term maintain inflation in the range of 2-6%.
India’s economy has been growing strongly and lower commodity prices have helped India achieve growth since 2014 while keeping inflation contained because of slow global economic growth. But this may be changing now. The expectation of pro-growth economic policies by the US president-elect Donald Trump has, on one hand, buoyed the financial markets in the United States shifting investors interest from the safe haven of bonds to stocks raising bond yields, and on the other hand, because American unemployment is low and near to full employment, has raised the prospect of faster rise in inflation ending the prolonged period of low inflation. This could become a contagion globally, igniting growth around the world. The world economy is showing signs of reflating. Industrial activity across the United States, Europe and China appears to be on an upward trend, and is pushing up commodity prices.
This change in global economic conditions has not gone unnoticed by the RBI. In its Fifth Bi-monthly Monetary Policy Statement, 2016-17 Resolution of the Monetary Policy Committee (MPC), the RBI has stated that:
“Global growth picked up modestly in the second half of 2016, after weakening in the first half. Activity in advanced economies (AEs) improved hesitantly, led by a rebound in the US. In the emerging market economies (EMEs), growth has moderated, but policy stimulus in China and some easing of stress in the larger commodity exporters shored up momentum. World trade is beginning to emerge out of a trough that bottomed out in July-August and shows signs of stabilising. Inflation has ticked up in some AEs, though well below target, and is easing in several EMEs. Expectations of reflationary fiscal policies in the US, Japan and China, and the waning of downward pressures on EMEs in recession are tempered by still-prevalent political risks in the euro area and the UK, emerging geo-political risks and the spectre of financial market volatility.
International financial markets were strongly impacted by the result of the US presidential election and incoming data that raised the probability of the Federal Reserve tightening monetary policy. As bouts of volatility fuelled a risk-off surge into US equities and out of fixed income markets, a risk-on stampede pulled out capital flows from EMEs, plunging their currencies and equity markets to recent lows even as bond yields hardened in tandem with US yields. The surge of the US dollar from late October intensified after the election results and triggered sizable depreciations in currencies around the world. Commodity prices firmed up across the board from mid-November on an improvement in the outlook for demand following the US election results, barring gold which lost its safe haven glitter to the ascendant US dollar. Crude prices have firmed after the OPEC’s decision to cut output.”
The RBI summed up its statement with an assessment of inflation thus:
“Turning to inflation, food prices other than vegetables are exhibiting sustained firmness and a pick-up in momentum. Another disconcerting feature of recent developments is the downward inflexibility in inflation excluding food and fuel which could set a resistance level for future downward movements in the headline. Moreover, volatility in crude prices and the surge in financial market turbulence could put the inflation target for Q4 of 2016-17 at some risk.”
Though good for Indian exports, the depreciation of the rupee against the US dollar could, in fact, put upward pressure on inflation in India because imports become expensive. This, when combined with strong economic growth, can raise inflation closer to the RBI’s upper limit of 6% as the Indian central bank recognizes.
Though monetary policy transmission when lending rates are lowered is being hampered by factors such as non-performing assets (NPAs) of commercial banks and the small size of India’s financial markets, when lending rates tick up the transmission is faster. To keep inflation within target, therefore, India may have to settle for slower growth by raising interest rates at some point.
The Goldilocks period of sustained strong growth in an environment of low global inflation may be coming to an end for India.