US Inflation and Impact on India

• 13 Nov 2021

Why in News

Over the last few days, the retail inflation in the US has risen to 6.2%, the highest year-on-year jump in 3 decades. These rising prices have cornered a lot of attention, both globally and in India.

Key Points

• About Inflation:
  
  • Mechanism: It is the rate at which prices increase over a given period. Typically, in India, the inflation rate is calculated on a year-on-year basis.
    
    • In other words, if the inflation rate for a particular month is 10%, it means that the prices in that month were 10% more than the prices in the same month a year earlier.
    • In India, inflation is primarily measured by two main indices — WPI (Wholesale Price Index) and CPI (Consumer Price Index) which measure wholesale and retail-level price changes, respectively.
    • India has adopted a flexible inflation targeting mandate of 4 (+/-2)%.
  • Effect of Inflation on People: A high inflation rate erodes the purchasing power of people. Since the poor have less money to withstand fast-rising prices, high inflation hurts them the hardest.
    
    • However, a moderate level of inflation is required in the economy to ensure that production is promoted.
• Reasons for Rising Inflation in US:
  
  • The Federal Reserve, the US central bank, targets an inflation rate of just 2%. Seen in that context, 6.2% inflation rate is a very sharp increase in prices.
  • Typically, inflation spikes can be assigned to either an increase in demand or a decrease in supply.
    • In the US, both factors are at play.
    • The pace of economic recovery has been much faster than the supply chain recovery, and this has worsened the mismatch between demand and supply, thus triggering a sustained price rise.
  • Demand Side Inflation: With the rapid rollout of the Covid-19 vaccination drive, the US economy posted a sharp recovery.
    
    • A part of the inflationary spike came from this unexpectedly fast recovery in all-round demand from consumers.
    • This recovery was further fuelled by billions of dollars pumped by the government to not only provide relief to consumers and those who lost their jobs, but also to stimulate demand.
  • Supply Side Inflation: The pandemic in 2020 led to widespread lockdowns and disruptions not just in the US, but across the world.
    
    • Companies let go of employees and sharply curtailed production.
    • In essence, the global supply chain of production hasn’t resumed production on pre-pandemic levels.
  • Inflation Globally: While the US has seen the sharpest increase in prices, inflation has surprised policymakers across most of the major economies, be it Germany, China or Japan.
• Inflation, Indian Perspective:
  
  • Inflation, the Pre-Pandemic Phenomena: While most other economies were surprised by a spike in inflation in the wake of the pandemic, India was one of those rare major economies where high inflation predates the pandemic.
    
    • The pandemic did make matters worse because of supply constraints even when in India demand has not yet recovered to pre-Covid levels.
    • Due to this, despite India entering a “technical” economic recession, the RBI has not once lowered its benchmark interest rates (repo rate) since May 2020.
    • The RBI has decided to continue with an accommodative stance as long as necessary to revive and sustain growth on a durable basis and continue to mitigate the impact of Covid-19 on the economy, while ensuring that inflation remains within the target going forward.
  • Core Inflation, the Worrisome Factor: While the overall inflation average appears quite manageable at present, it is the “core” inflation that is worrying.
    
    • Core inflation rate is the rate of inflation when we ignore the prices of food and fuel.
    • It is high, and now threatens to breach the RBI’s comfort zone.
    • India’s inflation may worsen in light of the global increase in prices.
• Effect of US Inflation on India:
  
  • When prices increase globally, it will lead to higher imported inflation. In other words, everything that India and Indians import will become costlier.
  • High inflation in the advanced economies, especially the US, will likely force their central banks to abandon their loose monetary policy.
  • A tight money policy in advanced economies would imply higher interest rates.
    
    • A tight monetary policy involves increasing interest rates to constrain borrowing and to stimulate savings.
  • That will affect the Indian economy in two broad ways.
    
    • Indian firms trying to raise money outside India will find it costlier to do so.
    • The RBI will have to align its monetary policy at home by raising interest rates domestically. That, in turn, may further raise inflation because the production costs would go up.

Source: IE