View: Growth, and not inflation is India’s real problem


By Ajay Chhibber

Rising inflation and declining growth is back in the news, with Q3 FY2020 growth at a low 4.7% and consumer price index (CPI) inflation over the upper limit of the inflation target regime of 6%. After reducing the repo rate by 135 basis points (bps) in 2019, the Monetary Policy Committee (MPC) has paused in lowering the interest rates, while keeping the stance accommodative.

Reserve Bank of India (RBI) has introduced other measures to enhance credit growth, such as longer-term repos and reprieve for loans to real estate and autos. Whether these will be enough to boost recovery remains to be seen, as credit growth remains at a low 6-7%.


Many analysts mistakenly believe that the inflation-targeting regime had been instrumental in lowering India’s inflation rate between 2014 and 2018. But India’s inflation trajectory is really driven largely by global commodity price movements, as one would expect in a mostly open economy.

When India was a more autarchic country, domestic factors — especially food-related supply shocks — drove inflation. But since India liberalised, inflation is largely driven by global commodity prices. But even before India opened up its economy, global commodity prices had sizeable effects on domestic inflation.

Organisation of the Petroleum-Exporting Countries (Opec)-driven oil price increases in 1974 had a huge effect on inflation in India in 1974-75. The wholesale price index (WPI) inflation for India mirrors the global commodity index, and the CPI inflation also matches it with a one-year lag (see charts). The decline in inflation came about because global commodity prices fell in 2014-15, and had very little to do with the introduction of inflation targeting.

Inflation remained low between 2000 and 2006 without any inflation-targeting regime, because global commodity prices were subdued. But after global commodity prices rose, inflation also rose in India, remaining high — until 2014, as part of the global commodity cycle.

If global commodity prices drive inflation, then mechanically targeting inflation through monetary policy can be downright harmful. In India’s case, in 2014-18, the real repo rate was kept at 250-300 bps, much higher than was necessary. This hurt growth, drove up the real exchange rate by attracting portfolio inflows, hurt export growth and damaged the goals of ‘Make in India’.

Look Under the Hood

Inflation-targeting is a fad that can do damage if the underlying factors driving inflation are not properly analysed and understood. There is also excessive focus on temporary price surges — for onions, vegetable, pulses, cereals, etc. These are best handled by supply-side and trade policy measures, not by inflation-targeting. To that extent, core inflation is a better measure of aggregate demand pressures in the system. Globally as well, central bankers take too much credit for the decline in inflation. Commodity price cycles explain much of the movements in world inflation.

Inflation targets have worked because they have coincided with falling commodity prices. And inflation has, to the surprise of most analysts, remained low in the US, despite the lowest rates of unemployment for the last 50 years because global commodity prices remain subdued. In Japan and Europe, despite vigorous attempts by central banks to increase money supply, the major worry remains deflation, not inflation.

RBI governor Shaktikanta Das has rightly initiated a review of the Monetary Policy Framework (MPF). This will reportedly focus on issues such as how to improve the transmission mechanism, what to target (headline or core inflation?), and how to ensure that RBI’s rate changes are passed on by banks.

These are all useful issues. But such areview should ask a more fundamental question: what are the factors that drive India’s inflation? If we don’t understand that, a mechanical review of MPF may not be so useful.

If (as the charts show) much of India’s inflation is driven by global commodity prices, then it is more useful to ask: how does imported inflation transmit to the domestic economy? How does it affect wages through food prices? How does it affect cost of production and transportation? How does it feed into investment costs?

How does monetary policy accommodate the pass-through of imported inflation and affect price expectations? What can be done to smoothen out spikes in inflation through reserves and exchange-rate mechanisms? How does one diversify the sourcing of key imported commodities, especially oil and gas?

Inflation has risen again in 2019 because global commodity prices rose in 2017/2018, and we are seeing them pass through into domestic prices. No need to panic and start taking policy decisions that may do more damage than good. With global commodity prices falling again in 2019 — and likely to fall further with the coronavirus — inflation in India will once again subside.

Dial ‘L’ for Recovery

The real problem facing India and the world economy will be growth, not inflation. India’s slump may have bottomed out. But we may at best get an L-shaped growth trajectory from now on. A misguided inflation-targeting regime now constrains India’s policy toolkit, which maybe badly needed in the coming year, especially with the coronavirus adding to the economic decline. Improving inflation-targeting is not the answer. That would be like shooting from the hip and running the risk of shooting one’s own feet.

The writer is chief economic adviser, Federation of Indian Chambers of Commerce and Industry (FICCI).

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