The story so far: India’s retail inflation dropped to a three-month low of 6.77% in October when compared to the same month last year. Wholesale price inflation also dropped significantly from rising at double digit rates in earlier months to 8.3% in October. The drop in inflation has led to hopes that the RBI has managed to gain control over price rise.

What caused the drop in inflation?

Economists attribute the drop in inflation in October to a favourable base effect. It should be remembered that retail inflation since the pandemic has been affected by lockdowns which served as a severe shock to the economy. Lockdowns affected the demand and supply sides in different ways, both when they were first imposed and subsequently lifted by the government. This may have led to unusual volatility in inflation figures since the pandemic. Hence, it may be hard to compare inflation figures of the current year, in which normalcy has largely returned to the economy, with those from previous years marred by stringent lockdowns. Easing food prices have also been cited as a reason for the recent drop in inflation. But it should be remembered that inflation refers to a general rise in the price level regardless of changes in individual prices. So, rise or fall in inflation cannot really be attributed to changes in the prices of individual goods and services.

How will the RBI react to the latest inflation figures?

Retail inflation at 6.77% is still above the RBI’s target inflation range, which is between 2% and 6%. Retail inflation has, in fact, remained above the RBI’s target inflation range for ten months now, due to which the RBI has had to write to the government explaining why it failed to meet its inflation mandate. So, despite the slight cooling down of inflation, economists expect the RBI to continue hiking interest rates over the coming months; the RBI may even want inflation to drop to around 4%. They, however, expect the pace of rate hikes to slow down with inflation seeming to ease gradually. It should be noted that the RBI raised rates by 50 basis points in its last three monetary policy committee (MPC) meetings this year. Economists believe that the RBI may opt for a 35 basis points hike during the next MPC meeting scheduled for December. If inflation continues to fall, the challenge for the central bank will be to control the pace at which it slows down rate hikes. This is because there is usually a time lag between monetary policy and its impact on inflation, which makes the setting of interest rates a tricky affair.

Has inflation peaked yet?

It is unclear whether the drop in retail inflation in October marks the beginning of a sustainable downtrend in inflation figures. In the past, inflation figures have cooled down temporarily only to rise again in subsequent months. So, it may be too soon to conclude that October’s inflation figures mark a turning point in inflation trends. Monetary policymakers are likely to be aware of this and may decide to wait and watch before signalling a decisive change in their policy stance. The RBI may also decide to keep the rate hike cycle going due to external pressures, particularly if domestic economic growth does not slump to alarmingly low levels as it raises rates. Although inflation in the U.S. has cooled down a little to 7.7% in October, it is still way above the U.S. Federal Reserve’s inflation target of 2%. This means that the U.S. Federal Reserve is likely to continue tightening its monetary policy stance well into next year. If so, the RBI may be forced to raise domestic interest rates as well or dig deeper into its foreign exchange reserves in order to prevent a slide in the rupee against the U.S. dollar.