Why Few Are Celebrating Low Inflation In India

Inflation in India has fallen sharply over the last five years. But why are so few people happy about it?

Revelers watch a firework during Diwali celebrations in Delhi, India. (Photographer: Prashanth Vishwanathan/Bloomberg)
Revelers watch a firework during Diwali celebrations in Delhi, India. (Photographer: Prashanth Vishwanathan/Bloomberg)

For the last decade, the conversation in India has centered around the need to bring down inflation and make it more predictable. It’s easy to remember corporate commentary on how high inflation is a deterrent for long-term investors. And how it is eating into disposable incomes and hence spending capacity. What India needs is low and stable inflation, it was often said.

Today, India has low and relatively stable inflation. But you would be hard pressed to find corporate executives gushing over the low inflation environment. In fact, we recently spotted a senior executive at an industrial conglomerate asking for “good inflation.”

Why is this?

The Cost Of Lower Inflation

Part of the answer lies in the sources of low inflation. As has been pointed out for some time now, it is mostly food inflation that has fallen and brought down headline inflation with it. The moderation in inflation on other goods and services, core inflation as economists call it, has been much more modest.

As has now been discussed extensively, a fall in prices of farm produce has led to lower rural incomes. Farmers are not earning much more than they were a year ago even if they are producing more. This means their ability to spend more is restricted. This, in turn, has hurt the many companies who target rural consumers with their goods and services.

But in theory, lower inflation should leave more money in the hands of consumers and lead to higher spending. Why has it not played out that way?

There could be two reasons for this. In rural areas, the downside in incomes appears to have eroded any positive effects of lower inflation. Among urban consumers, the persistent inflation in goods and services other than food may have restricted the real and sentiment impact of lower food inflation.

To be sure, it is possible that if inflation is lower but consumption has not gone up meaningfully, then savings have risen. But there is no clear data to prove this yet.

Nominal Growth Matters

The broader issue with lower inflation is that nominal growth matters, in many cases, much more than real or inflation-adjusted growth.

Nominal growth represents the total amount of spending on goods and services in an economy. If the total pie is not growing or is growing slower than before, then it gets tougher for a company to grow within that pie. In most cases, they would need to fight to gain more market share to maintain their pace of expansion or accept lower growth.

An extended period of low nominal growth can have other consequences. If companies see slower growth in revenues but wages remain sticky, their ability to hire more and create jobs gets constrained. This is particularly true if both real and nominal growth are slow, as has been the case in India.

Lower nominal growth also hurts the government.

Since fiscal parameters, such as fiscal deficit etc, are calculated using nominal GDP, lower growth in the latter can push up the fiscal deficit unless the government adjusts its spending plans accordingly. The government’s revenue collections also get impacted since taxes are paid on nominal growth in revenue. Lower revenue growth means lower growth in tax collections, unless tax rates are tinkered with.

Inflation Is Down. Interest Rates? Not So Much.

The third reason for the low enthusiasm about India’s low inflation environment is that while inflation has fallen sharply, interest rates have not.

This was highlighted by Neelkanth Mishra of Credit Suisse in a recent interview with BloombergQuint. While we have seen all the negative side effects of inflation, all the positive side effects, which would have been significantly lower interest rates, have not come about, Mishra said.

The reason for this is two-fold. At first, the RBI and the monetary policy committee, over-estimated inflation. Even when it became clearer that headline inflation was coming in lower than expected, the MPC remained worried about the high core inflation.

After raising rates twice in 2018, the MPC has now cut rates by 50 basis points so far this year. At least another 25 basis point rate cut is likely. But inflation is starting to rise now just because of statistical base effect, which means the window for rate cuts may be limited. It is important to point out here that India is now a flexible inflation-targeting economy. The targets have restricted the central bank’s ability to shuffle priorities between growth, inflation and financial stability as it may have in the past.

Even the rates cuts that have been announced have failed to impact actual borrowing costs. Tight liquidity conditions and high government borrowings have meant that borrowing costs have remained high. Mishra thinks that interest rates should be 2 percent lower and that the MPC needs to cut rates by 100 basis points. He also believes they need to do it sooner rather than later.

Lower Inflation: Then And Now

The last time India saw a step-change in the inflation scenario was perhaps in the 1990s.

Back then, the inflation rate declined from an average of 11 percent during 1990-95, to about 5.3 percent from 1995-96 till the end of the decade. In response to the falling inflation, the bank rate, which at the time was one of the benchmark policy rates, fell from a peak of 12 percent in 1997 to 6 percent by 2003.

In the current period, the extent of fall in inflation has been similar. CPI has fallen from a peak of 11 percent in 2013 to under 3 percent now. Even if one expects that the current bout of low inflation will not last, the MPC will likely ensure that it remains within its flexible target band of 4 (+/-2) percent. Still, the fall in inflation has been substantial.

In response to this fall in inflation, the benchmark policy rate has fallen from 8.5 percent at the end of 2012 to 6 percent now.

To be sure, broader economic conditions then and now are not comparable and neither is the framework that governs monetary policy. Still, the change in the 10-year bond yield then and now drives home the point. Between 1999 and 2003, the 10-year yield dropped from 12 percent to 5 percent. Since 2013, the 10-year yield has dropped from 8 percent to 7.2 percent now.

No surprise then that few in India are cheering low inflation in India.

Why Few Are Celebrating Low Inflation In India

Ira Dugal is Editor - Banking, Finance & Economy at BloombergQuint.