There are moments in the lives of central bankers when they cease to exult over unexpectedly low inflation and consider what it is that is causing prices to behave well. The inflation print of 2.14% for June might be one such moment.
Looking past the usual explanations of financial market economists on base effects and sequential drops in food prices, a headline inflation print that is a good couple of percentage points below the target of 4% might be telling us something about a sluggishness of demand that no statistical trope can mask.
The need to fret becomes compelling when inflation prints are seen in conjunction with other indicators, such as loan demand and piles of surplus cash at banks. Credit growth measured year-on-year for June was a little over 9%, and cash surplus reached a peak of ₹9 tn in early July before RBI started mopping it up. The credit growth rate for the same period in June 2024 was, incidentally, over 19%.
What lessons should RBI draw from this? Standard business cycle theory would advise it to fear not. The fall in inflation is likely to be the result of past efforts at monetary tightening that are paying off. It is impossible for central banks to get things exactly right. With his oft-quoted 'Arjuna's eye' on inflation, ex-governor Shaktikanta Das might have overdone monetary compression a tad, resulting in the super-low inflation rates.
With inflation seemingly under control, all Sanjay Malhotra needs to do is reverse the process. He seems to have done this in good measure with reductions of half-a-percentage point each in the repo rate and CRR. He might want to do a little more, but the key lesson that business cycle theory offers him is the virtue of patience. Monetary policy works with lags. Malhotra should stop fretting over current growth or demand and wait for his labour to bear fruit - perhaps by the end of the year or a few months later.
However, there's a problem if one sees the lack of demand as a long-term structural problem rather than a neat cyclical story. Both consumer demand and private consumption have been flagging, at least since 2017, and the attempt to push them up to levels compatible with a sustained 7%-plus growth rate has been unsuccessful.
It is possible to go further back to search for causes of this structural slowdown, but 2020 - the year of Covid - might be a good place to start. The recovery from the consumption drop was robust, but there seems to have been a sizeable element of pent-up or revenge spending that was bound to peter out. Economists might brandish conflicting data to either question or support the view that the economic recovery was uneven or not, but most consumer-facing companies would attest that the recovery was K-shaped, with a bias against the mass market.
Besides, post-2020 geopolitical risks ratcheted up with two wars - Ukraine and West Asia. Automation found an upward inflection point as AI made its arrival as a usable, scalable innovation. A new US president and his protectionist policies brought a real risk of a compression in global trade and a domestic American recession.
Companies dislike uncertainty in decision matrices as much as weak demand. If, indeed, the private investment rut has continued in India long after Covid waned, it is difficult to blame Indian companies for being too timid. A farm sector recovery in 2024 promised to even out the K-shape of the post-Covid trajectory, but it was replaced by concerns about the 'hollowing out' of the middle class, with white-collar job losses particularly in IT-related sectors. The fear, stoked by some commentators, is that as AI gathers steam, an entire swathe of mid-tier jobs is at risk.
What does this mean for RBI? If structural factors are, indeed, the reason for muted credit growth, monetary policy has a somewhat limited role to play. As the current combination of massive excess liquidity and weak credit growth has shown, more accommodation can give the impression of an emerging 'liquidity trap', where interest rates fail to move the needle. This could hurt broader sentiment in the economy if it becomes the dominant economic narrative.
The post-Covid period saw a sharp increase in household debt. From an average of 35% in 2019, it climbed to 42% of GDP at the end of 2024. While this might still be lower than levels in other emerging economies, such a sharp increase has challenges. If monetary policy lowers interest rates, it does bring down EMIs of households. However, if banks use easy money to expand their retail portfolios at a time when employment and income flows are uncertain, there is a risk of loans going bad, threatening financial stability.
Finally, if we do believe Milton Friedman's claim that inflation is ultimately a monetary phenomenon, leaving too much excess cash in the system might exacerbate inflation pressures if there are supply shocks in food and fuel. RBI might want to curb enthusiasm about reflating the economy a little.
Looking past the usual explanations of financial market economists on base effects and sequential drops in food prices, a headline inflation print that is a good couple of percentage points below the target of 4% might be telling us something about a sluggishness of demand that no statistical trope can mask.
The need to fret becomes compelling when inflation prints are seen in conjunction with other indicators, such as loan demand and piles of surplus cash at banks. Credit growth measured year-on-year for June was a little over 9%, and cash surplus reached a peak of ₹9 tn in early July before RBI started mopping it up. The credit growth rate for the same period in June 2024 was, incidentally, over 19%.
What lessons should RBI draw from this? Standard business cycle theory would advise it to fear not. The fall in inflation is likely to be the result of past efforts at monetary tightening that are paying off. It is impossible for central banks to get things exactly right. With his oft-quoted 'Arjuna's eye' on inflation, ex-governor Shaktikanta Das might have overdone monetary compression a tad, resulting in the super-low inflation rates.
With inflation seemingly under control, all Sanjay Malhotra needs to do is reverse the process. He seems to have done this in good measure with reductions of half-a-percentage point each in the repo rate and CRR. He might want to do a little more, but the key lesson that business cycle theory offers him is the virtue of patience. Monetary policy works with lags. Malhotra should stop fretting over current growth or demand and wait for his labour to bear fruit - perhaps by the end of the year or a few months later.
However, there's a problem if one sees the lack of demand as a long-term structural problem rather than a neat cyclical story. Both consumer demand and private consumption have been flagging, at least since 2017, and the attempt to push them up to levels compatible with a sustained 7%-plus growth rate has been unsuccessful.
It is possible to go further back to search for causes of this structural slowdown, but 2020 - the year of Covid - might be a good place to start. The recovery from the consumption drop was robust, but there seems to have been a sizeable element of pent-up or revenge spending that was bound to peter out. Economists might brandish conflicting data to either question or support the view that the economic recovery was uneven or not, but most consumer-facing companies would attest that the recovery was K-shaped, with a bias against the mass market.
Besides, post-2020 geopolitical risks ratcheted up with two wars - Ukraine and West Asia. Automation found an upward inflection point as AI made its arrival as a usable, scalable innovation. A new US president and his protectionist policies brought a real risk of a compression in global trade and a domestic American recession.
Companies dislike uncertainty in decision matrices as much as weak demand. If, indeed, the private investment rut has continued in India long after Covid waned, it is difficult to blame Indian companies for being too timid. A farm sector recovery in 2024 promised to even out the K-shape of the post-Covid trajectory, but it was replaced by concerns about the 'hollowing out' of the middle class, with white-collar job losses particularly in IT-related sectors. The fear, stoked by some commentators, is that as AI gathers steam, an entire swathe of mid-tier jobs is at risk.
What does this mean for RBI? If structural factors are, indeed, the reason for muted credit growth, monetary policy has a somewhat limited role to play. As the current combination of massive excess liquidity and weak credit growth has shown, more accommodation can give the impression of an emerging 'liquidity trap', where interest rates fail to move the needle. This could hurt broader sentiment in the economy if it becomes the dominant economic narrative.
The post-Covid period saw a sharp increase in household debt. From an average of 35% in 2019, it climbed to 42% of GDP at the end of 2024. While this might still be lower than levels in other emerging economies, such a sharp increase has challenges. If monetary policy lowers interest rates, it does bring down EMIs of households. However, if banks use easy money to expand their retail portfolios at a time when employment and income flows are uncertain, there is a risk of loans going bad, threatening financial stability.
Finally, if we do believe Milton Friedman's claim that inflation is ultimately a monetary phenomenon, leaving too much excess cash in the system might exacerbate inflation pressures if there are supply shocks in food and fuel. RBI might want to curb enthusiasm about reflating the economy a little.
(Disclaimer: The opinions expressed in this column are that of the writer. The facts and opinions expressed here do not reflect the views of www.economictimes.com.)
Abheek Baruah
The writer is former chief economist, HDFC Bank