January’s inflation data served us a reminder of RBI’s challenge

This column had earlier argued that the Indian inflation problem is less severe than in most other large economies, based on two measures of distance. First, how far inflation in a country has strayed away from the underlying inflation target. Second, how many standard deviations is current inflation away from the average of the past 10 years. What that column missed was examining the persistence of high inflation in various countries, where the Indian record is less impressive. The Reserve Bank of India is clearly worried about the stickiness of inflation. Core inflation has been high for nearly three years now, despite sharp gyrations in economic activity through this period.

One likely consequence of persistently high inflation is that people begin to demand higher nominal wages to protect their standard of living. These higher nominal wages feed into costs that companies then try to pass on to consumers. This is the common view about how an inflation spiral can begin. A lot of the commentary on the inflation situation in many rich countries also focuses on red-hot labour markets in these economies.

However, various measures from the Indian labour market do not suggest that such a process has been active in India over the past three years, though nominal rural wages have begun to outpace inflation over the past three months. Inflation expectations of households are also slightly higher than they were before the pandemic, but not significantly so.

Why? There are three possible explanations. One, the Indian labour market has not adequately recovered from the effects of the pandemic shock. Workers have dropped out of the labour market because they have stopped looking for jobs. The labour force participation rate estimated by the Centre for Monitoring Indian Economy is still a few percentage points below its pre-pandemic level, though it has gained 150 basis points in November and December. The possibility of more people rejoining the labour force by actively looking for work may have capped the growth of nominal wages in India.

Two, the actual inflation experienced by citizens may be less than what the official numbers suggest. The government was running a massive programme to give free food to 800 million people after the pandemic hit, in effect a way to support incomes of poor households whose monthly budgets are dominated by expenses on food. It is likely that the availability of free food has moderated demands for higher nominal wages. The government has now restructured the food subsidy with a much-needed eye on fiscal savings.

Three, Indian households at the upper end of the income pyramid, and especially those with stable incomes, saw their savings shoot up during the country’s two major covid lockdowns. These were forced savings. There was also likely an increase in precautionary savings during the pandemic. The combination of forced plus precautionary savings led to a large increase in the stock of financial savings by households. These have now been spent down, but not completely. Even now, the stock of excess household savings is around five percentage points of gross domestic savings. Such excess savings could possibly have acted as a financial buffer despite rising prices.

All the three explanations listed above are guesses. There is a final possibility which requires us to shift our attention from the actions of households to the actions of firms. Is inflation being driven by the pricing decisions of firms above the usual passing on of higher costs to consumers?

The Polish heterodox economist Michal Kalecki argued that the degree of monopoly in an economy determines the extent of mark-ups by businesses, and that such mark-ups distribute income from workers to firms.

Some private sector economists, such as Pranjul Bhandari of HSBC and Sajjid Chinoy of J.P. Morgan, have written in recent months about the possibility that higher concentration in many sectors has increased the pricing power of dominant firms. Such a higher degree of monopoly power could arise from the pressure on smaller firms as well as higher import duties on many products in recent years. This is a possibility that needs further attention.

The persistence of core inflation near the upper end of the inflation target for nearly three years is surely a worry. The analytical puzzle is why such persistence has not had strong second-round effects of the sort we see in many rich countries, especially in the labour market. This column has listed some possible reasons. That also gives reason to hope that, despite the January inflation surprise, India is still on a gradual path of disinflation.

Niranjan Rajadhyaksha is CEO and senior fellow at Artha India Research Advisors, and a member of the academic advisory board of the Meghnad Desai Academy of Economics