Modi's 4 per cent inflation target vital for the health of Indian economy

The rupee has been fairly stabilised to weather external exchange rate fluctuations caused by economic meltdown, Brexit and devaluation by countries like China and so on, including a possible US Federal Reserve rate hike on the cards.

India's macroeconomic numbers have improved and inflation, though on the rise, is being targeted and reined in by the new policy framework put in place by the Monetary Policy Committee.

The repo rate, at which the central bank lends to other banks/monetary institutions, has been kept at 6.5 per cent and the cash reserve ratio, the proportion of deposits banks have to keep with the Reserve Bank of India (RBI), has stayed at four per cent. All other rates have been kept static as before.

The RBI has ensured adequate liquidity both in terms of lending and market liquidity through open market operations, and balanced it closer to neutrality, which is highly appreciable.

Outgoing RBI governor Raghuram Rajan has also reassured that the current accommodative stance of monetary policy and comfortable liquidity conditions should provide a congenial environment for reinvigoration of aggregate demand conditions.

Other than that, a good monsoon, big ticket tax reform (Goods and Services Tax) and a good monetary policy regime all added together augurs well for the economy.

The RBI has abandoned its focus on the wholesale price index (WPI) and instead shifted it to the consumer price index (CPI), the latest reading of which is a cause for concern. The RBI may not any more focus on supply factors to rein in inflation but will instead closely monitor the impact of aggregate demand on CPI inflation.

The framework's upper limit for CPI tolerance has been breached, with retail (or CPI-based) inflation hitting an all-time high of 6.07 per cent in July. Food costs - a key component in both indices - account for a large extent of it.

An International Monetary Fund (IMF) working paper recently released on India's food inflation, titled "Understanding India's Food Inflation: The Role of Demand and Supply Factors", briefly summarises the issue as follows:

1. High share of food expenditure in total household expenditure and correspondingly high weightage in CPI;

2. Inflation expectations which are anchored by food inflation; and

3. Wage indexation to consumer price inflation and thereby indirectly to food inflation.

It talks about the importance of these factors in shaping India's inflation dynamics and determining the conduct of monetary policy, particularly the presence of large second-round effects of food price shocks.

Also read: Goodbye, Raghuram Rajan. Good luck, Urjit Patel

The results suggest that given the large weightage on food in household expenditure, robust real income growth in the recent decade has resulted in substantial demand-side pressures.

As supply of key agricultural products did not keep pace with real personal consumption growth, growth in food prices has outpaced that in non-food prices by about three-and-a-half per cent since 2006-'07.

As real personal consumption growth is expected to be robust and supply to be relatively sluggish in the coming years, it seems India's inflation dynamics will continue to be shaped by the trend in relative food prices.

The estimates suggest that in the absence of a stronger food supply response, relative food inflation can contribute about 1¼ percentage points to headline CPI inflation annually.

If private consumption growth picks up to seven per cent and supply growth response remains at this historical level, Indian food inflation is likely to exceed non-food inflation by two-and-a-half to three percentage points per year.

Therefore, monetary policy would need to react appropriately to both supply shocks as well as underlying inflation trends, particularly in the context of the recently adopted flexible inflation targeting.

Achieving India's long-term inflation target of four per cent will hinge on enhancing food supply, market-based pricing of agricultural produce, and reducing price distortions.

Also read: Will Raghuram Rajan's monetary policy yield fruit in new fiscal?

Outlook for supply can only improve with better monsoon predictions. There is a flip side to this favourable uptick of supply rising real rural income (RRI). This, particularly, will add to the already large weightage of food in household expenditure and translate into substantial demand side pressures that far outpace the supply side gains.

The stickiness of food costs can undermine the steady gains in the fight against price rise and the rise in CPI inflation. The effect of inflation, after all, is the hardest on the poor in the form of tax on poverty.

If the Indian economy is to maintain its current growth and respond well to the stimulus provided, given that external demand is lacklustre, domestic consumption will have to be the engine of economic growth.

It is precisely this consumption demand that will receive impetus from salary and pension payouts of the Seventh Pay Commission.

The government's fiscal discipline must ensure that its already increased expenditure does not fan inflation to a point where the whole exercise of economic experts of the nation is to meet the challenge of containing food cost-led price rise and increase in CPI inflation.

Prime Minister Narendra Modi's categorical stand in his Independence Day speech to back the four per cent retail inflation target clearly amplifies the political intent to keep price gains through monetary and fiscal discipline waiting to be shaped by the central bank's new governor-designate Urjit Patel.