Inflation divergence & Interest rates: Current economic complexity

Metro India News | Hyderabad 

A bit of inflation is healthy in promoting savings, capital formation, employment additions, and wealth appreciation. But a bit of anchoring and monitoring are important to avoid economic hazards of inflation which could be due to demand side or supply side. Demand side inflation is when demand is more than supply. A higher increase in government spending or business investments cause demand side inflation. Supply side inflation occurs when input prices increase. In demand side inflation, as demand increases, prices rise. In supply side inflation as supply decreases, prices rise.

The transmission of increased demand into increased prices and rise in inflation takes more time in demand side inflation. The time lag could be 6 to 18 months. It is because businesses meet increased demand by using their excess inventory or by increasing production. Prices rise after full utilization of production capacities. In supply side inflation, as input costs rise, production costs of goods and prices rise. Since price increases will reduce demand, manufacturers decrease production quantities. These two actions increase prices further almost immediately. Therefore, in supply side inflation the transmission occurs quickly within 1 to 6 months.

Manufacturing and services are increasingly dependent on input supplies from across the globe. Due to this, cost chains across the world get triggered. Supply side shortages create bullwhip effect where more stocks are buffered fearing continued or increased shortages. This behaviour increases demand, shortages, and prices. Inflation could also be due to shortage of labour, which is mostly a domestic phenomenon. As businesses pay more to get labour, they pass on the increased costs to customers. Such rise in both income and costs results in wage-price spiral without any positive economic effect.

When businesses face supply side inflation, they try to reduce or absorb costs. But businesses with less competition exploit the situation by disproportionately rising prices which is greedflation. Supply side inflation usually starts as a relative price change. It happens when price of an item proportionately increases more than prices of other items. Oil price rises and lower harvests cause such relative price changes. Since oil is a foundational item, its price rise enters the cost structure of all items and in a couple of short cycles, the relative price rise inflation becomes general price rise inflation.  

Demand side inflation is usually a general inflation phenomenon. This arises when system has more money to chase fewer goods. When money supply increases, except for items such as salt and soaps, demand for almost all the goods increases. Currently, the inflation in India is on supply side. It is caused by increase in oil prices, depreciation of rupee, and food supply concerns. Wholesale Price Index (WPI) inflation of April 2026 was 8.30% while Consumer Price Index (CPI) was 3.48%. Such wholesale to retail inflation divergence occurs when increased input prices are yet to be fully passed on to the final consumers. 

The divergence is also because CPI has higher share of food and beverages whose prices have not increased steeply. Further, unlike WPI which does not include service costs, CPI has services, whose costs have not increased very high. The May 2026 WPI and CPI are scheduled for release in 2nd week of June 2026. However, understanding from the price trends, WPI of 8.30% in April 2026 may have decreased by 2% to 2.5% in May 2026. Similarly, CPI of 3.48% in April 2026 may have increased by 0.50% to 0.75% in May 2026.  

The depreciating rupee, higher credit growth, sufficient liquidity in the market, and higher interest rates in US may influence RBI to rise policy interest rates. Also, if RBI perceives that inflation expectations should be anchored failing which inflation will further rise, RBI may increase policy rates as it did during similar supply side inflations in 2010-11 and 2022-23. Correspondingly, considering that CPI is still within 2% to 6% tolerance band, unemployment is higher at 5.2%, and despite credit growth rate at 16.2%, economic growth is facing headwinds, RBI may act pragmatic by not increasing the policy Repo Rate.

— Dr. Kishore 

Nuthalapati

The author is the Regional Director of PRMIA, US for Hyderabad Chapter.  He is serving as the CFO of BEKEM Infra Projects Pvt Ltd, Hyderabad. Views are personal and are not of any organizations he is or was associated with.