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What is ‘new normal’ of inflation
Inflation is the biggest enemy for a central bank like the Reserve Bank of India. Very often, RBI governors highlight the need to rein in the inflation to cut benchmark borrowing and lending rates. Low interest rates are needed to allow businesses and consumers to spend more and stimulate economic growth.
However, to do that RBI needs to be convinced that the inflation rate is consistently going down.
Many experts have suggested to RBI that the high inflation scenario should be considered as a ‘new normal’. Experts think that rising global commodity prices and rural wages could result in the average inflation rate staying high in India.
In a recent speech at Bankers’ Club in New Delhi, RBI governor D Subbarao explained why RBI does not agree with experts.
He gave reasons for not subscribing to the theory. Here are some pointers:
What is ‘new normal’ inflation:RBI has consistently maintained that it prefers an inflation range of around 4-4.5% with an idea to bring it down to 3%. A section of experts argue that the average whole sale price inflation rate has hovered around 8.8% over the last 3 years against 6% in three years to August 2008 or before the global financial crisis. Hence, they suggest that RBI should accept the ‘new normal’ range of inflation of over 7%. This automatically makes the current inflation situation less worrisome, it is argued. It also makes a case for a sharp cut in borrowing rates.
Why cut rates:RBI has cut the benchmark repo rate, the rate at which it lends to banks, to 7.75% from 8.25% over the past six months. However, experts, businessmen argue that RBI should make deeper cuts in borrowing rates. Low interest rates are necessary to reduce the cost of borrowing for companies and individuals. Low borrowing cost allows companies and individuals to increase expenditure that in turn creates demand for goods and services. This stimulates the economic growth. India’s growth rate fell to 5% from a high 8.5% a year earlier.
What RBI thinks: D Subbarao does not think the need to accept the new normal inflation rate. RBI’s main job is to manage expectation of the inflation. RBI closely tracks factors that influence inflation. A key contributor to inflation is the inability of markets to get goods when the demand goes up. This is called the supply-side constraint. RBI expects the government to invest in the infrastructure to improve efficiencies in markets. Inflation in India is largely a structural problem, according to RBI.
Global commodity prices:Global commodity prices are unlikely to rise sharply going forward, according to RBI governor D Subbarao. For example, the global demand for oil could slow going forward. This is because growing domestic production and near flat consumption could see the US become self-sufficient in energy by 2030. The thrust of the Reserve Bank’s argument is that the current and projected trends for the global energy scenario do not provide a persuasive case for raising India’s ‘normal inflation’.
Rural inflation: The other point Subbarao made was about rising rural wages and prices. The government job guarantee scheme has increased the income in rural India. This has also resulted in demand for food rising. RBI does not think that the government has the fiscal capacity to continue entitlements and welfare programmes at this level. “The Government’s embrace of fiscal responsibility will act as a self-limiting check on the wage-price spiral,” he said. Going forward, rural wages may not grow that fast.
India’s consumer price inflation (CPI) was recorded at 10.9% for February 2013, higher than 10.79% in January 2013. India has the second highest rate of inflation, according to a report in the Mint newspaper. CPI is the weighted average of a basket of goods and services consumed by people. While the Reserve Bank of India tracks the trend in the wholesale price index inflation or WPI to take a call on interest rates, it does not ignore the high consumer inflation completely. Food prices rose 13.7% in February.