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%.
- 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