India could face high inflation, low growth

The Reserve Bank of India's (RBI) bi-monthly monetary policy announced on April 5 maintained a status quo on rates but it contains a strange contradiction. This time, the RBI has projected Consumer Price Index-based inflation or CPI inflation to follow a downward trend and remain in the 4.7%-5.1% band. In February, however, the Monetary Policy Committee (MPC) of the central bank had forecast that the CPI will be in the 5.1%-5.6% range for the first half of 2018-19.

Having lowered inflation expectations, the RBI has raised its GDP growth projections by 80 basis points (bps) to 7.4% from 6.6%.

Here lies the puzzle

The growth-inflation tradeoff is a well-known paradigm. The Philips curve explains this tradeoff beautifully. The Phillips curve is an economic theory by A. W. Phillips which says that inflation and unemployment have a stable and inverse relationship. The concept posits that with economic growth comes inflation, which in turn should lead to more jobs and less unemployment.

But an ET online analysis shows India will probably witness a higher inflation and lower growth scenario.

Why inflation could see an upward trajectory
The era of oil-price declines seems to be over, at least for the time being. India continues to import 80% of its crude demand and rupee has a weakening bias, keeping landed costs of fuel high. In CPI, which is the anchor for monetary policy, fuel products have a weight of almost 3% (the fuel and light combined has 7%) and this will measure the direct impact of a hike in fuel price. A 10% increase in fuel costs, for instance, will thus push up CPI inflation by almost 25 bps, ceteris paribus.

There is an indirect impact also by way of a cascading effect through the transportation segment, which adds another 15 bps or so to the CPI.
Meanwhile, the trajectory of food inflation is not yet clear. This is the largest component in the CPI basket with food and beverages constituting 54%. The MPC has admitted upside risks to inflation due to the Union Budget announcement of a 1.5-fold hike in MSP for farm produce.

Moreover, the baseline assumption now is that monsoon prospects are good. But what if spatial and temporal distribution turns bad? This remains unanswered. In addition, one must be wary of the statistical phenomenon called the 'base effect. Average CPI inflation for April 2017-February 2018 was 3.52%. The low base will cause an upside to inflation, in addition to risks emanating from oil-price shocks and exchange-rate pass through.

Rupee depreciation will play a role
The rupee exchange rate is another variable that needs to be considered. Latest data shows the real effective exchange rate of the rupee (REER) against dollar (exchange rate adjusted for inflation) is at 101.28. The implication is rupee overvaluation of at least 1.28% at the current juncture. When landed costs of imports rise due to rupee depreciation, it brings forth imported inflation, and the quantum depends on the composition of those items in the CPI and wholesale price index (WPI) basket.

The end result: High inflation, low growth
In all probability, inflation will be higher rather than lower as the RBI is expecting. It is more likely to print closer to the 5.1% to 5.6% range rather than below 5%. With inflation likely to read above 5% next year, an 80 bps upward revision to growth looks too optimistic.

Ground realities also lead us to similar conclusions. Exports have slowed down and a trade war is underway. Moreover, high inflation reduces real interest rates, erodes savings, reduces investible surplus, and acts as a drag on growth. For the present, it looks like a high-inflation, low-growth scenario.