The Cause and Effect of rising Inflation

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The Cause and Effect of rising Inflation

  • Inflation in April is at its highest in the last 8 years, and almost twice the RBI's target.
  • Some factors have kept inflation high since October 2019, now it is impacting consumers and the economy.

The Current Inflation Scenario

The retail inflation had grown by 7.8% in April.

  • In other words, the general price level Indian consumers faced was almost 8% higher than it was in April last year.
  • This is not only the highest rate in the last eight years but also almost twice the inflation rate targeted by the Reserve Bank of India.
  • According to law, the RBI is required to maintain retail inflation at a level of 4%. (fall as low as 2% or rise as much as 6%)

Effect of Russia-Ukraine War

The war in Ukraine and the associated inflation via higher prices of crude oil are a significant contributor.

  • Retail inflation has been high since October 2019 and touched the 4% mark just once since then.
  • In all other months, it was higher than 4% & regularly breached the 6% mark.
  • Inflation in India has been above 6% since the start of 2022. (before Russia’s invasion of Ukraine happened in February)

Current Inflation Driver

Headline inflation has been above the 4% mark since 2019-20.

  • It is calculated using the Consumer Price Index with three main categories:
    • Food Items - which account for 46% of the index.
    • Fuel & Light - with a weight of 7%.
    • Core - all other items, which make up the remaining 47%.

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  • It is important to understand that a 10% increase in food items will obviously raise the overall inflation far more than a 10% increase in fuel prices.
  • In 2019-20, when overall inflation was 4.8%, the main reason was a 6% spike in food prices.
  • In 2020-21, when the pandemic hit the economy, food prices rose by an even larger factor (7.3%) and even core inflation rose by 5.5%.

Impacts of High Inflation

  • It reduces people’s purchasing power:
    • The poor are the worst affected because they have little buffer to sustain through long periods of high inflation.
  • It reduces overall demand:
    • The eventual fallout of reduced purchasing power is that consumers demand fewer goods and services.
    • Non-essential demands such as a vacation get curtailed while households focus on the essentials.
  • It harms savers and helps borrowers:
    • High inflation eats away the real interest earned from keeping one’s money in the bank or similar savings instruments.
    • Borrowers are better off when inflation rises because they end up paying a lower “real” interest rate.
  • It helps the government meet debt obligations:
    • The government, which is the single largest borrower in the economy, benefits from high inflation.
    • Inflation also allows the government to meet its fiscal deficit targets.
  • Mixed results for corporate profitability:
    • In the short term, corporates, especially the large and dominant ones, could enjoy higher profitability because they might be in a position to pass on the prices to consumers.
    • For many companies( smaller ones)- persistently higher inflation will reduce sales and profitability because of lower demand.
  • It worsens the exchange rate:
    • High inflation means the rupee is losing its power and, if the RBI doesn’t raise interest rates fast enough, investors will increasingly stay away because of reduced returns.
  • It leads to expectations of higher inflation:
    • High inflation changes the psychology of people.
    • People expect future prices to be higher and demand higher wages.

Exam Track

Prelims Takeaway

  • Retail Inflation
  • Inflation Drivers
  • Impacts of High Inflation