RBI Annual Report 2019-20: Economy To Grow, Inflation To Ease By Q4FY21

The economy could turn around and inflation could ease by the fourth quarter of the ongoing financial year, according to the RBI’s model that most closely reflects reality.

Amid rapidly evolving epidemiological and economic scenarios, the central bank has so far refrained from giving estimates of how deep the Indian economy could contract.

But according to an econometric model by the RBI, that finds mention in its annual report for 2019-20, economic activity will reach its trough in Q4 FY21 and recover gradually thereafter, in a scenario that’s closest to reality. Inflation, which was as high at 6.7% Q4 FY20, is projected to ease till Q4 FY21, as per the scenario.

The model has three main economic agents: households, firms and the government. Because of the lockdowns imposed to curb the Covid-19 outbreak, people have been forced to stay at home, resulting in reduced labour supply to firms. Consumption fell as a result of non-availability of non-essential items and fall in incomes; and restricted people-to-people contact stalled the momentum of the pandemic.

The first scenario, as projected by the RBI, impacts the the supply side of the economy by decreasing labour supply and its productivity. The second scenario also considers the increase in marginal cost—the added cost of every additional unit of a product or a service. This is the scenario the RBI considers closest to reality.

To assess the macroeconomic implications of both scenarios, a third scenario is simulated where the government doesn’t impose a lockdown.

In all cases the model assumes:

• Economic activity is worst hit in April, as suggested by various high frequency economic indicators.
• The output gap drops to -12% of the potential for this period.
• Infections peak in second half of August 2020.
• Employment during lockdown drops to around -32% of its pre-lockdown level, based on the combined projections of Centre for Monitoring Indian Economy and the RBI’s KLEMS employment estimates.

Led by fall in demand, inflation falls under the first two scenarios. Under the second scenario, however, the decline in inflation is less steep and short-lived. Due to higher marginal cost, firms respond to the squeeze in profits by curtailing production and labour demand. Wages see a lower rise and economy goes through a large contraction. However, the recovery from the pandemic is faster in this scenario on account of fewer opportunities for people to-people interactions.

Under the third scenario, in which the government does not impose a lockdown, the pandemic is widespread and peaks in the second half of January 2021 with a very slow recovery. This causes persistent labour shortage and the supply shock produces a lasting impact on inflation and the output gap, which corresponds to a permanent upward shift in inflation and a downward shift in potential output, respectively.