Inflation conundrum: Is the Maradona theory at work?

Until a few weeks ago, central bankers from Jerome Powell to Shaktikanta Das believed that inflation would be transitory. Suddenly, it appears to be lasting.

An inflation reading of 6.95% in India in March, a percentage point above the central bank’s upper tolerance threshold, has stirred the markets. Economists are convinced that the Reserve Bank of India (RBI) will begin raising rates in June.

As it juggles between the prospect of failing to meet its inflation target and the desire to fuel economic growth, an unconventional combination of monetary tightening and comforting commentary may be the norm.

“With the inflation outturn materially to the upside and momentum still rising, we are lifting our terminal repo rate forecast to 6% by the fiscal third quarter, with a 25 basis points rate hike in each of the next eight MPC meetings,” said Sonal Varma, economist at Nomura Securities. “The rising cost of living could lead to higher wages. Rental inflation remains benign, but is likely to catch up with rising house prices. Higher food and fuel prices will also spill over into higher inflation expectations.”

Inflation as measured by the CPI for March surprised on the upside, the gauge registering a 17-month high due to elevated food and commodity prices. With much of the fuel price increases that began late March yet to flow in, the pressure in the coming months could be more as it feeds into the broader economy.

Growth-focused Governor Das took a baby step last week by putting inflation ahead of growth and focusing on withdrawal of accommodation. It bumped up the inflation forecast by 120 basis points to 5.7% with 6.3% in the June quarter, and 5.8% in September.

This trajectory makes the probability of the Governor having to write a letter explaining why the inflation prints for three quarters are rather high. Duvvuri Subbarao as governor explained inflation citing the sharp rise in the cost of his haircut despite a receding hairline. Das may choose a few lines from lyricist Shailendra!

“All that has happened all around the world has introduced a completely new element into the scheme of things,” Governor Shaktikanta Das told reporters last week. “We are watchful of the emerging trends. How the war progresses, how the commodity prices and the crude oil prices behave in the coming months and accordingly whatever action is warranted, we will take them, and all our actions will be tailored accordingly.”

While convention is to tighten the accommodation and then gradually move to raise rates, the magnitude of price pressures may not provide much room. It now appears that the rate increase may well be in the next meeting on June 8.

“We revise our CPI forecasts to 5.8% for the fiscal year, and now expect four 25 basis point rate hikes, starting from June’s MPC meeting,” said Rahul Bajoria, economist at Barclays.

The central bank still believes that demand is not back to the pre-Covid levels warranting the initiating of a tightening cycle.

The RBI, which has tools beyond interest rate, could apply the liquidity measures as a big chunk of the excess liquidity is finding its way back to the central bank vaults itself.

Currently, surplus liquidity in the system is at about ₹7.09 lakh crore. A big chunk of it could be absorbed either through Variable Rate Reverse Repo auctions, sell/buy swap in the currency market or via various other programmes. Despite tightening, the RBI may keep the liquidity in surplus at around ₹2 lakh crore as it looks to expand credit. It has the flexibility to even raise rates without shifting its stance to neutral since it shifted to neutral when the policy repo rate, the rate at which RBI lends to banks, was at 5.75% in June, 2019.

Inflation calls for higher cost of funds. What if it could be achieved without tightening policy rates much? The RBI may not have raised rates, but its commentary has done the work. The benchmark bond yield has moved 38 basis points to 7.29%, from the low of 6.91% the day before the policy review.

What the Bank of England Governor Mervyn King called the Maradona theory of interest rates may already be at play. In the 1986 World Cup, Argentine great Diego Maradona ran 60 yards in a straight line beating five defenders to score his second goal. The defenders were expected to move to the right or left; so he ran straight. “Monetary policy works in a similar way. Market interest rates react to what the central bank is expected to do,” said King. That may just have begun in India.