Meeting 4% inflation target unlikely in near-term

The government recently set an inflation target of 4% for the next five years with a margin of 2% on the up- and down-side.

In July, both wholesale and retail inflation were at a two-year high of 3.55% and 6.07%, respectively, mainly led by a rise in food prices in the country, which has been on the uptick for a few months now.

Wholesale food articles inflation rose to 11.82% in July compared to 8.18% in June. Retail food inflation in the month grew to 8.35%, up from 7.79% in June.

At this level, the wholesale and retail inflation are above the comfort level of the Reserve Bank of India (RBI), given that it wants to bring down retail inflation to 5% by FY17-end and 4% by FY18-end, India Ratings said in a report.

While, going ahead, food prices are expected to cool, but it will only happen in the later part of the year when the kharif crop is harvested. Which means, the inflation target of 4% may not be met in the near future.

In the August 9 monetary policy review, the last one before Raghuram Rajan steps down from the governor's chair, the central bank, while leaving the key policy rates unchanged, maintained that there was an upside risk to inflation, going ahead. This was, “given the stickiness in food and services inflation,” the Ind-Ra report said.

“Rearing up of the food along with non-food inflation will continue to keep inflationary expectations on the upside, Dun & Bradstreet's Lead Economist Dr Arun Singh, said.

"While a greater area has been covered under sowing of the Kharif crops, the course of the inflation will be clear on the availability of the food crops in the market post the harvest period only," he added.

Even a recent International Monetary Fund paper, raised question marks over RBI's ability to target inflation through monetary measures saying that the central bank may not be able to meet the inflation target. “In the absence of effective and reliable links between the policy instruments controlled by the RBI and aggregate demand in the Indian economy the public may lack confidence that the RBI is able to deliver on its announced inflation target, making the target more difficult (and costly) to achieve,” IMF said.

Apart from this, there are other inflationary pressures in the near-term which will keep the government's target out of reach.

The government accepted the recommendations of the 7th Pay Commission panel, which hiked the salaries of nearly one crore government employees and pensioners. This is likely to cost an outflow of over Rs 1.02 lakh crore as it pays arrears for January-July in August.

“The build up of inflationary expectations owing to the 7th Pay Commission awards will make achieving a target of 4% CPI inflation in the near-term unlikely,” D&B said.

India Ratings also flagged the 7th Pay Commission as an upside risk to inflation. “The implementation of the 7th Central Pay Commission award is likely to directly impact house rents, which is a component of CPI.The impact of house rent allowances on inflation expectations will need careful monitoring by the central bank to pre-empt a generalisation of inflation pressures,” it said.

Bank of Merill-Lynch expects food inflation and agflation to ease in August with food prices coming down from peaks. A good monsoon (2% above normal) should pull down agflation and inflation. Although food inflation increased to 8% in July from 7.5% in June on a poor summer rabi crop, prices have already started coming off in August. BofA expects retail inflation to ease to 5.1% in August.