As inflation rises, the RBI hikes interest rates to control the money supply in the system. It is simple economics - greater the demand, higher will be its price. So, the more money people have to spend, the faster will be the rise in prices, i.e., inflation. By increases the interest rates, the RBI aims to reduce the amount of money available to be spent. As demand falls, inflation comes down. This is idea. Recent data suggests that inflation measured by the Wholesale Price Index (WPI) fell to a 5-year low of 2.38% in September. Consumer inflation too fell during the month, but marginally so, to 6.46%. It may now seem like the path is clear for the RBI to cut interest rates in the next policy. Yet, it seems unlikely.
Here are five reasons why:
Inflation is measured on a comparative basis. Every month, the prices are compared from the prices in the same month the previous year. The steady fall in inflation has started in the past few months. Before that, growth in inflation was pretty steep. As a result, any growth in prices this year would be lower on a comparative basis. This is called the high base effect. For example, if prices stood at Rs 100 last year, and they grow to Rs 105 this year, the growth is 5%. After that, if the prices grew to Rs 110 - by the same Rs 5 - the growth would be 4.76%, lower than 5%. A high base effect could often mask the lack of improvement in inflation scenario. The real improvement in inflation would be seen only after December once the high base effect ends.
Food and fuel are two of the largest baskets in the goods measured by the inflation indices. Both wholesale as well as consumer price indices fell on the back of a fall in food prices in August. Wholesale food inflation dropped to 3.52% from 5.15%, while the consumer food inflation fell to 7.6% from 9.1%. However, this could reverse in the near future, especially on the back of a poor monsoon, which could affect crops sown in summer. Moreover, the floods in various parts of the country too could have a bearing on inflation if agricultural productivity is drastically impacted.
Inflation takes into account prices rises in multiple goods and services. In the month of September, prices of services-oriented components grew slowly, contributing to the lower inflation. This, analysts believe, is not sustainable in the long run, thus acting as risk to inflation in the future. The fall in global prices of crude oil too have contributed to the fall in inflation. However, as crises in the Middle-East worsen, prices of oil could shoot up in the near future. This could push up fuel prices in India, which depends on imports for its oil needs.
There are many factors that contribute to inflation in India. Increase in rural wages is one of the biggest contributors, along with the rise in minimum support prices of food crops and costs of food production, a RBI study found. These factors cannot be targeted by simple monetary policies. This could continue to push inflation higher. Moreover, as the Indian grows, consumption and demand could rise. This could stoke inflation once again.
Another key factor is the stability of the rupee and the current account deficit. The rupee depreciated once again to Rs 62/$ levels as the dollar strengthened across currencies. This could push up costs of goods and services, which rely on imports. Moreover, the trade deficit - the amount India owes to the world in foreign currency for trade reasons - widened again to a 16-month high of $14.25 billion in September. This is also potentially inflationary as it could cause the rupee to depreciate further.
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