Context

High inflation has reduced the fiscal space available for a rate cut.

RBI target of 6% breached.

• CPI at 7.35 %: Retail inflation, as measured by the consumer price index (CPI), has surged to 7.35 per cent in December 2019.
• Latest inflation data seems to corroborate fears articulated by the Monetary Policy Committee (MPC) in its December meeting.
• In the meeting, MPC refrained from cutting the benchmark repo rate.

Consequences for the economy

• Reduced scope for fiscal slippage: High inflation reduced the space for further easing of policy rates.
  • Even after clarity over the extent of the Centre’s fiscal slippage emerged.
• Rise in yield for 10-year securities: The 10-year G-sec yields have reacted sharply to these developments, rising to 6.67 on Tuesday.
  • Offsetting operation twist: Rise in yield resulted in offsetting the impact of the RBI’s recent open market operations.
• Inflation targeting under stress: The combination of weak economic activity and higher than expected supply-side inflationary pressures has put the inflation-targeting regime under test.

Reasons for the inflation rise and chances of easing

• Food prices rise: Much of the rise in the headline inflation number can be traced to higher food prices.
  • Food inflation has risen to a near six-year high of 14.12 per cent in December 2019, up from 10.01 per cent in the previous month.
  • Vegetable prices have surged to 60.5 per cent in December, contributing nearly 3.7 percentage points to the headline numbers.
• Chances of ease in coming months: While vegetable crop cycles tend to be short, and supply-side pressures may ease in the coming months.
  • The stickiness in prices of protein items is likely to provide a floor for food inflation.

Bleak outlook for inflation easing

• No short-term return to normal level: Food inflation is unlikely to revert to previous levels in the short term.
• Household inflation expectations, a key metric in the MPC’s assessment, are more responsive to food inflation, this will further exert upward pressure on MPC.
• A factor of hostilities in the Middle East: The uncertainty over oil prices on account of hostilities in the Middle East, adds to the bleak outlook for inflation.

Conclusion

With limited fiscal space for a meaningful stimulus, the government intends to support the economy during this rough patch, and return growth to a higher trajectory.

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