How far would India’s inflationary pressures upset its growth momentum?

The IPD of national income aggregates pertaining to GDP and GVA where both goods and services are more comprehensively covered, provides a more reasonable guidance regarding the movement of prices. However, IPD is not directly measured, and its data are available only on a quarterly and annual basis. Movements in IPD can be seen as a weighted sum of movements in the WPI and CPI. The relative weights attached to the WPI and CPI inflation in the IPD-based inflation are not explicitly stated. We have derived these through a threshold regression equation. Our results indicate that when the WPI inflation exceeds a certain limit (2.48%), the weight associated with the WPI inflation vis-à-vis the CPI inflation in determining the IPD-based inflation, increases considerably. Prior to this limit, the weight attached to the CPI inflation is higher.¹

Recent trends: reaching historical highs

In May 2022, the CPI inflation remained elevated at 7.0%, easing only slightly from 7.8% in April 2022. It is notable that the CPI inflation has remained at or above the RBI’s upper tolerance limit of 6% for five consecutive months. The WPI inflation increased to a historic high of 15.9% in May 2022, signalling continued upward pressure on CPI inflation in the next few months. This inordinately high WPI inflation has been driven mainly by two commodity groups namely, primary articles which includes food items as well as crude, and fuel and power which include electricity and mineral oils. The latest data available for the IPD-based inflation shows that it increased to an unprecedented level of 10.4% in 4QFY22.

A relatively longer history as shown in Chart 1 depicts three notable patterns: (1) significant upward movement of WPI inflation, (2) increase in CPI inflation but with a lag and by a lower margin, and (3) IPD-based inflation tracing these trends, lying in the intermediate space but closer to the WPI line.

Curbing inflation while supporting growth: active role of fiscal policy

Inflation and growth are two critical inputs in the formulation of both monetary and fiscal policies. In India, the monetary policy framework (MPF) has guided the RBI to remain more focused on controlling inflation while the Ministry of Finance at the Center has been left with the relatively broader responsibility for managing growth while keeping in mind the FRBM norms.

Pushed by sustained inflationary pressures, the RBI, in two consecutive meetings held in May and June 2022, increased the repo rate by 40 and 50 basis points respectively. Together, these have taken the repo rate to 4.9% from 4%, a level at which it was retained from May 2020 to April 2022. Alongside, the RBI also indicated gradual withdrawal of its accommodative stance and revised upwards, its FY23 CPI inflation forecast to 6.7% from 5.7% projected earlier. The RBI changed its base assumption regarding the average price of Indian crude basket in FY23 to US$105/bbl. from US$100/bbl. as assumed in April 2022.

With respect to the FY23 GDP growth, the RBI has retained its forecast at 7.2%, same as in April 2022. The April 2022 forecast was revised down from 7.8% estimated earlier in February 2022. Many multilateral agencies including the World Bank, the IMF and the OECD have also reduced India’s growth prospects for FY23. The lowest amongst these is that by the OECD at 6.9%. Even at this revised lower level, India’s GDP growth prospects for FY23 are tangibly above the global average growth projection and the growth projections for major peer countries.

One positive spinoff of the high inflationary trends is that the IPD-based inflation turned out to be 10.0% in FY22, its highest level since FY11. Correspondingly, nominal GDP growth was at 19.5%. This, combined with a buoyancy of 1.7, yielded a growth of 33.8% in Center’s gross tax revenues (GTR) in FY22, enabling a marginal reduction in Center’s fiscal deficit relative to GDP at 6.7% as compared to the revised estimate of 6.9%.

Going forward, in FY23, the IPD-based inflation may remain high given the current inflationary trends. We estimate that an IPD-based inflation of 10% or more may be feasible implying a nominal GDP growth of about 18%. Combined with a buoyancy of 1.2, Center’s GTR may show a growth of close to 22%, exceeding the budgeted growth of 9.6% for FY23 by a wide margin. Applying this growth of 22% on the actual collections for FY22 as per the CGA, the magnitude of Center’s GTR in FY23 would exceed the corresponding budget estimates by nearly INR5.5 lakh crore, benefitting both the central and state governments. This additional fiscal capacity may be used to bolster both government consumption and investment expenditure after taking into account, inflation-linked increases in expenditures on items such as food and fertilizer subsidies. Some of this additional fiscal capacity may also be used for further reducing excise duty and VAT on petroleum products thereby applying a brake on the inflationary momentum.

Major advanced economies are aggressively increasing their policy rates to contain the inflationary pressures. With CPI inflation in the US reaching a 40-year high of 8.6% in May 2022, the Federal Reserve, in its June 2022 monetary policy meeting, increased the benchmark Federal Funds rate by 75 basis points to a range of 1.5% to 1.75%, its largest rate hike in a single meeting since 1994. The Fed officials expect the year-end Federal Funds rate to rise to 3.4%, up from 1.9% as projected earlier in March 2022². With the sustained uplifting of the US Fed interest rate, there would continue to be an outflow of foreign exchange from India and a reduction in the rate of foreign exchange inflows into India. This may put pressure on the exchange rate which would remain another important cost side pressure on inflation since there would be a continued increase in import cost. India’s balance of payments situation would also deteriorate adversely affecting both inflation and growth. The RBI may have to increase the repo rate in the next few MPC meetings. It is thus the fiscal policy which will have to play a strong growth-supporting role. In FY23, real GDP growth may turn out to be 7.2% or higher contingent upon a strong fiscal stimulus.