By Ishita Misra
Since 1950, India has maintained a steady control over the inflation rate in the country and has had one of the lowest interest rates in comparison to other developing countries. This is because the inflation rate has a tremendous impact on the economic growth of the country and hence, shapes the policies followed by it. With the roll out of a new tax regime and the ongoing monsoon in India, Morgan Stanley, a global brokerage firm, had predicted the inflation for 2017 to be 3.6 per cent. However, due to the relatively mild impact of GST and the monsoon, Morgan Stanley has lowered its inflation forecast for 2017 to 3.1 per cent.
The brutal trade-offs of inflation
High inflation rates reduce the real value of money and have an adverse effect on economic growth. The reduction in the value of money is not immediately followed by a rise in wages. Hence, it results in a slowdown of consumption which, in turn, decreases demand, slows down production, and adversely affects the GDP. High inflation rates also cause banks to increase their interest rates to prevent losses. This discourages people from borrowing from banks and investing in the economy. Investment is also discouraged by the uncertainties that arise from high inflation rates. The resultant decrease in investment is particularly harmful to developing economies like that of India.
Developing countries need massive investments for the development of each sector, particularly the infrastructure sector. According to the Finance Minister, out of the $646 billion worth of investment that will be needed in the infrastructure sector over the next five years, a huge amount is unmet. Therefore, it is essential for India to keep a control over its inflation rate in order to ensure rapid economic growth.
The changing forecast
One of the downfalls of switching to the new tax system of GST was the impact it could have had on the inflation rate. The rate is decided based on the Consumer Price Index (CPI) which measures changes in the price level of consumer goods and services bought by households, over a number of years. As most of the tax rates under GST have been lowered for the goods and services that come under the CPI basket, the new tax system has had a minimal impact of the CPI and therefore, the inflation rate. Other factors that led to a change in the forecast are the persistent fall in food inflation and mild impact of a rise in house rent allowance and the ongoing monsoon.
Due to these factors, the brokerage firm revised the forecast for headline CPI to 3.2 per cent from 3.6 per cent for 2017, and to 4.3 per cent from 4.6 per cent for 2018. The firm also said that the headline inflation rate reached a low in June and is expected to follow a trajectory of a gradual rise. It predicts that there will be a rise in food inflation and fading of high bases of comparison, which will lead to rise in the prices of food and therefore, headline CPI inflation.
Key changes in the monetary policy
Lenders are often more severely affected than borrowers when it comes to inflation. As inflation decreases the value of money, the lenders lose money if the interest rates are kept constant. Hence, banks design and modify their monetary policy in compliance with the forecasted inflation rate. With a cut in the forecasted inflation rate, RBI might reduce the benchmark lending rate by at least 0.25 per cent in its third bi-monthly monetary policy during the meeting in August. RBI had left the key rates unchanged during the June monetary policy review to make sure that inflation will stay subdued. The change in monetary policy is taking place after the central bank held the rates at 6.25 per cent for four consecutive reviews, citing risks to inflation. The expectation of the rate cut is not only due to the prediction of a lower rate of inflation but also to promote investment in the industrial sector as its growth continues to remain weak. Meanwhile, the RBI is expected not to change the Cash Reserve Ratio or the Statutory Liquidity Ratio because of the adequate liquidity in the market.
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