Context:

A high base effect has helped ease the headline retail inflation rate to a 25-month low in May 2023.

About Inflation:

• Inflation refers to the rise in the prices of most goods and services of daily or common use, such as food, clothing, housing, recreation, transport, consumer staples, etc. 
• It measures the average price change in a basket of commodities and services over time. 
• Inflation is indicative of the decrease in the purchasing power of a unit of a country’s currency. This is measured in percentage.
• Importance: A certain level of inflation is required in the economy to ensure that expenditure is promoted and hoarding money through savings is demotivated.

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Types of Inflation:

• Stagflation: Stagflation is a unique combination of high inflation and stagnant economic growth, accompanied by high unemployment
• Headline Inflation: Headline Inflation is a measure of the total inflation within an economy,including commodities such as food and energy prices (e.g., oil and gas), which tend to be much more volatile and prone to inflationary spikes.
• Core Inflation: Core inflation is the change in the costs of goods and services, but it does not include those from the food and energy sectors.
  • This measure of inflation excludes these items because their prices are much more volatile.
• Disinflation: Disinflation refers to a decrease in the rate of inflation, meaning prices are still rising but at a slower pace. 

Main Causes of Inflation:

• Cost-Push Inflation: Cost-push inflation occurs when prices rise because production costs increase, such as raw materials and wages. 
• Demand-Pull Inflation: Demand-pull inflation can be caused by strong consumer demand for a product or service. 
• Monetary Factors: Excess circulation of money leads to inflation as money loses its purchasing power.
• Built-in inflation: Built-in inflation, also known as inflationary expectations, occurs when people expect prices to rise in the future and adjust their behavior accordingly.

Effects of Inflation:

• Inflation Erodes Purchasing Power: An overall rise in prices over time reduces the purchasing power of consumers since a fixed amount of money will afford progressively less consumption.
• Inflation Disproportionately Impacts Lower-Income Consumers: Lower-income consumers tend to spend a higher proportion of their income on necessities than those with higher incomes. 
• Increased production costs: Inflation can lead to higher production costs for businesses as the cost of raw materials, labor, and other inputs shoot up.
• Uncertainty and reduced investment: High or unpredictable inflation rates can create uncertainty in the economy.
• International competitiveness: If the domestic inflation rate is higher than that of its trading partners, the country’s exports may become more expensive, leading to a decrease in demand for its goods and services in the global market.
• Deceleration in economic growth: When inflation is high, the cost of living gets higher as well, which ultimately leads to a deceleration in economic growth. 

How is Inflation measured?

• 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.

The Monetary Policy Framework:

• In 2016, the RBI Act, 1934 was amended to provide a statutory basis for the implementation of the flexible inflation targeting framework.
  • Inflation Target: Under Section 45ZA, the Central Government, in consultation with the RBI, determines the inflation target in terms of the Consumer Price Index (CPI), once in five years and notifies it in the Official Gazette.
• Accordingly, in 2016, the Central Government notified 4 per cent Consumer Price Index (CPI) inflation as the target for the period from August 5, 2016 to March 31, 2021 with the upper tolerance limit of 6 per cent and the lower tolerance limit of 2 per cent.
• In 2021, the Central Government retained the inflation target and the tolerance band for the next 5-year period – April 1, 2021 to March 31, 2026.

Monetary Policy Committee:

• Section 45ZB of the RBI Act provides for the constitution of a six-member Monetary Policy Committee (MPC) to determine the policy rate required to achieve the inflation target.
• The Reserve Bank of India Act, 1934 was amended by Finance Act (India), 2016 to constitute MPC.
• Quorum: The quorum for a meeting shall be four Members, at least one of whom shall be the Governor and, in his absence, the Deputy Governor, who is the Member of the MPC.
• Decision Making: The MPC takes decisions based on a majority vote. In case of a tie, the RBI Governor will have the second or casting vote.
  • The decision of the MPC would be binding on the RBI
• Functions: The MPC is entrusted with the responsibility of deciding the different policy rates including MSF, Repo Rate, Reverse Repo Rate, and Liquidity Adjustment Facility.
• Composition of MPC:
  • Section 45ZB says the MPC shall consist of:
    • the RBI Governor as its ex officio chairperson,
    • the Deputy Governor in charge of monetary policy, 
    • an officer of the Bank to be nominated by the Central Board
    • three persons to be appointed by the central government.

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Challenges in addressing inflation:

• Food Price Volatility: Food inflation has been a persistent challenge in India due to factors such as supply-demand imbalances, weather conditions, and inadequate storage and distribution infrastructure.
• Structural Constraints: India grapples with structural constraints that hinder the smooth functioning of markets and contribute to inflationary pressures. Inefficiencies in agricultural supply chains, including inadequate storage and transport infrastructure, result in post-harvest losses and price distortions. 
• High dependence on Imported commodities: India relies on imports for various commodities, including crude oil, edible oils, and pulses. Fluctuations in global commodity prices can directly influence domestic inflation.

Way Forward:

• Monetary policy: The Reserve Bank of India (RBI) plays a crucial role in controlling inflation through monetary policy. 
• Fiscal discipline: The Government should focus on prudent fiscal policies that promote fiscal discipline, including reducing the fiscal deficit and ensuring efficient allocation of resources.
• Supply-side reforms: Addressing structural bottlenecks and improving supply-side factors can help alleviate inflationary pressures.

News Source: The Indian Express