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There is bad news for Indian Finance Minister, Arun Jaitley. The impact of the Goods and Services Tax (GST) on prices has been counted adversely for the second month running and has increased the uneasiness of the Finance Minister who had promised the country that the GST would have no or marginal adverse impact on prices. Both the wholesale inflation and consumer price inflation rose for the second month in August.

The retail or consumer price inflation rose to a five-month high of 3.36% in August, fuelled by strong increases in prices of food items. The retail inflation was estimated at one percentage point higher in August compared to 2.36% in July, 2017.

India’s wholesale inflation accelerated to a four-month high of 3.24% in the same month in line with the trend in retail inflation on the back of rising food and fuel prices. Food inflation increased to 5.75% in August from 2.15% a month ago, much of it was due a sharp rise in onion prices –
up 88.5%.

Fuel inflation rose by 10% as petrol and diesel prices continued to soar due to rising crude oil prices and high central and state taxes. Fuel prices have risen to a three-year high.  But since the rise in fuel prices is a global phenomenon and their prices back home are left to market forces, the government has little control over it. So far as taxes on fuels are concerned, the Finance Minister has said in a recent interview to a business magazine that “… in the last two years I have not added any additional tax as petrol is concerned. The international price of petrol, there is a temporary spike because the hurricane in the United States has reduced the refining capacity by 13%. Once the refining capacity is restored, the prices will come down and therefore the present price will also come down.”

But that will be in future. Right now, calling for a cut in the cess on transport fuels, industry chamber Assocham has said recently that the consumer is getting restive about a three-year high in the petrol prices and feels the market pricing mechanism is being distorted by tax hikes on petrol and diesel.

Even after these sharp rises in prices last August, both the retail and wholesale price indices are still within the Reserve Bank of India’s prescribed boundaries and thus, may not warrant any immediate action from the central bank. But experts argue that a rise in inflation for two straight months has reduced the chances of another rate cut by the Reserve Bank of India, which has a central inflation target of 4%. In August, the RBI cut its main policy rate by 25 basis points to 6%, the lowest since 2010, while keeping its policy stance at “neutral”.

This brings us to a very interesting predicament of India’s inflation analysis. The financial experts and our economists now study the inflation trend in relation to whether RBI will cut or raise the policy rates rather than how a change in inflation counting will affect the public.

Traditional economic theory suggests a cut in interest rate when prices go down and vice versa. This is based on an age-old economic concept that propensity to save rises when interest rate or the return on savings goes up. Alternatively, propensity to consume increases when return on savings (in this case interest rate) goes down. The later premises will not only increase funds in the system though higher savings but will also push up demand.

And thus, the industry bodies demand a cut in the interest rate to avail not only funds at lower cost but also to prop up demand for their goods. This has been the story all along but despite rate cut the private sector investment has remained illusive.

Pankaj Patel, President of FICCI, seems to be more pragmatic so far as the issue of inflation and rate cut is concerned. Patel argues that “the need for a further cut in interest rates to stimulate demand and growth in the economy cannot be overemphasised. From the perspective of jobs and fresh employment opportunities, all policy levers at the disposal of government and the RBI should be utilised even as further steps are taken to augment agro-production and improve supply side logistics.” Even otherwise, there is no empirical truth that cut in interest rate props up investment or consumption demand. As for consumption, a cut in interest rate may affect it adversely as a large section of the households who do not have pensions would be compelled to save more for future exigencies fearing a lower return on their savings. On the other hand, investment probably depends more on the expected future return on capital than its borrowing cost. If return is higher than the cost of funds, industrialists would be prompted to invest even at higher rate of interest. Alternatively, if the expected return is low investors would not like to invest even if the cost of fund is low.

This is reflected in the falling credit growth of Indian banks. Bank credit growth declined to a 20-year low in 2016-17. The combined advances of 32 listed public sector banks were up just 1.7% last year over 2015-16, growing at their slowest pace since 1995-96. To note, the interest rate in 1995-96 was substantially higher that what it was in 2016-217.  And if part of this fall was due to a virtual freeze in new loans by public sector banks, the low demand from the industry was equally responsible for the deceleration in credit growth.This would suggest that the inflation issue in the country should focus more on its impact on common people since the magnitude of the interest rate which is used to control inflation, has little impact on investment.