The inflation conundrum: the protection provided by the government through tax cuts can be partial, and it can only be done to a certain extent

How effective are governments and central banks in controlling the economy? This question has become relevant in the face of high inflation across the world. Everywhere, central banks have started to raise their key rates or plan to do so. Governments are also trying to control inflation, a recent example in India being the Centre’s decision to reduce excise duties on petroleum products. Will this help bring inflation down?

Inflation has become a multi-pronged problem, with various factors contributing to its rise. The global case of crude oil prices reaching the current level of around $110 a barrel is one. Crude oil indirectly enters the prices of agricultural products as it is used for transportation, running generators, supplying inputs, etc. as this has led to shortages and higher prices. This fueled prices for other edible oils; Indonesia spiced things up with its palm oil export ban some time ago (it has since been withdrawn). A third factor is that wheat supply has been affected as exports from Russia and Ukraine have been pulled out of the global pool. This led to shortages and rising prices, leading India to respond by banning its exports. Fourth, all food manufacturers will now face the challenge of higher wheat and edible oil costs, which will lead to higher input costs; the peak must be transmitted to consumers at some point.

Baked goods, restaurants and processed foods will become more expensive in this regard. Fifthly, Russia is also a major supplier of oil, gas, iron ore and coal. With the sanctions announced by the West, the supply of these raw materials in the world basket has decreased, leading, once again, to a rise in inflation. The indirect impact is felt in the price of fertilizers, the production of which uses large quantities of natural gas. Sixth, after the pandemic, Indian manufacturers of goods and services passed on rising input costs to the consumer, hence the CPI of goods and services increased. Therefore, a war endemic to one region had vast ramifications on the supply of raw materials as well as global inflation.

The steps taken by the Indian government are commendable. Despite strong pressure on fiscal balances, a decision was taken to lower excise duties on petroleum products and edible oil imports; this could reduce the rate of inflation. But he won’t be able to bring it down to, say, 4% or even 5%. Taxes are essential in the case of energy products because their share in the total price can reach two thirds. But, for others, the benefit can only be at the margin. Lower taxes on the import of edible oils can lower the price by, say, Rs 5-10 per litre, but cannot bring retail prices back to the levels of Rs 120-140 seen last year. It will still have to shell out, if not Rs 200 more per litre, something in the region of Rs 180-200. Therefore, the protection that can be provided by the government through tax cuts may be partial, and there are limits to what this can be done.

The positions of central banks are also quite unique. We all know that around 85-90% of the components of the CPI are not linked to leverage, which means that interest rates cannot influence the demand for these products. In fact, what may be the deciding factor in reducing demand is ironically inflation, as high edible oil prices will reduce consumption by the average household; that’s something that higher pension rates can’t do.

Therefore, the action of RBI and probably the forward-looking measures on raising interest rates can be scrutinized in two ways. The first is that to the extent that rates are raised, the pace of activity will slow, which is essential for monetary theory to work. This will ensure that in this situation a parallel force on the demand side does not develop. The second is that RBI will have to try to return to the positive real interest rate situation. This is a challenge for all central banks. Even for the Fed, faced with 8% inflation, at a 3% rate, a negative real rate will persist until inflation recedes. The same goes for us. If inflation remains at, say, 6% for this year, can we have a repo rate higher than 6% (or even 6.5%)? This will definitely hurt the investment. Therefore, market expectations should be moderate.

There are limits to which policies can work. All governments would like their citizens to be happy. Even the most selfish regimes would ideally like to have a happy population to stay in power. Yet, as seen during the pandemic, negative growth has occurred everywhere. Likewise, maintaining near-zero interest rates in the West has not quite brought resilience or strength to these economies. This is the conundrum of inflation today.

The author is Chief Economist, Bank of Baroda
Views are personal

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