High inflation could hurt the NDA before 2019

Higher costs of borrowing could deter investment and economic recovery

Consumer Price Index – the benchmark measure of inflation – hit a four-month high of 4.87% in May. The development was not entirely unexpected. Fuel prices have been rising in the past few months, while the rupee has been depreciating. For an oil-importing country like India, the confluence of these two factors was bound to push up prices. Core inflation – which excludes food and fuel prices – has also increased by 25 basis points from April to 5.95% in May. One basis point is one-hundredth of a percentage point. This shows that prices of manufactured goods are also increasing fast . When seen with the fact that the factory output grew at 4.9% in April, 30 basis points less than what economists had been expecting, this raises question: is the economy is already reaching its growth potential? If the trend continues, the monetary policy committee of the Reserve Bank of India might once again increase interest rates and also change its “neutral” stance in the policy announcement on August 1.

The political economy implications of rising inflation and interest rate can be adverse for the government. Higher cost of borrowing will dampen investment, which can decelerate economic recovery in an election year. Unless the government takes a cut in its petroleum revenues, tailwinds to inflation are unlikely to ease significantly. Cutting prices through lowering taxes will entail lesser government spending. The government might be looking at raising Minimum support Prices for farmers before elections. This may push up inflation, and interest rates. Higher interest rates can make industry unhappy.

What is interesting is that this government is the first one which will be facing such complications. Before the finance ministry and RBI agreed to make price stability the anchor of monetary policy in 2016, North Block used to have much more leeway in influencing interest rates.