7th Pay Commission HRA allowance impact: In RBI's own words, horrific facts revealed!

7th Pay Commission HRA allowance: The Reserve Bank of India (RBI) has always mentioned its concerns, when it came to 7th CPC based salary hikes and the impact on CPI inflation that affects all of India. The fear of 7th Pay Commission HRA allowance was such that RBI maintained status quo for quite some time, until the central bank was forced to hike interest rate between June to August 2018 policy, something that is not considered good for the public or the industrialists as it makes loans more expensive. However, much to the relief of central government employees and others, many analysts, believe that the impact of HRA allowance would not be much, and RBI will manage to overcome inflation problems.

Currently, India’s policy repo rate stands at 6.50%, and CPI inflation at 3.77% during the month of September 2018 slightly higher compared to 3.69% of the previous month. Also, the latest number was higher from 3.28% in the same month of previous year. RBI in a recent study, showed evidence of how HRA has impacted Inflation.

Consumer price index (CPI) inflation is the headline measure used by the Reserve Bank of India (RBI) for the conduct of monetary policy. In terms of the provisions of the RBI Act, the target for headline inflation is 4 per cent with a tolerance band of +/- 2 per cent. As soon as this is threatened, 7th pay commission is one of the factors that carries a threat, RBI takes action to ensure inflation does not rise any further as it will hurt everyone concerned.

How 7th pay commission affects inflation? Fuelled by the 7th CPC HRA effect, housing inflation in CPI rose from 4.7 per cent in June 2017 to 8.2 per cent by December, hovered around that level in 2018 up to July before edging down in August and September as the HRA effect started to wane. 

What is more, for those watching 7th pay commission HRA effect, alongside the uptick in housing inflation, headline inflation edged up with the share of housing in headline inflation gradually rising from 0.5 percentage points in June 2017 by 35 basis points to 0.85 percentage points during January to July 2018. 

RBI said, "The current experience is not one off. Such large increases have in past too pushed up inflation significantly. The past effect of 7th pay commission’s HRA awards on inflation is available only from CPI for industrial workers (CPI-IW) produced by the Labour Bureau since CSO’s CPI did not exist then. To assess this impact, CPI-IW is reconstructed by substituting the observed housing index with an estimated housing index using pre-CPC housing momentum of the immediate preceding three years."

It added, "Since the housing index in CPI-IW is adjusted once in every six months, unlike headline CPI, the impact was not gradual but came as step increases – first in January 2018 and then July when the housing index is reset. Due to higher weight of housing, the impact of HRA revision was much higher in CPI-IW."

Following the 7th CPC HRA award, the share of housing in CPI-IW inflation rose in January 2018 and gained substantial proportion by July-August 2018. Adjusting for the HRA effects, the July and August print of CPI-IW inflation at 5.6 per cent was markedly lower at 1.7 per cent. 

In the past, using this approach, it is seen that CPI-IW inflation was pushed up by 200 and 400 basis points following the 5th and 6th CPCs, respectively. 

Hence, RBI believes that the 7th Pay commission HRA risk needs to be addressed for the following reasons: 

First, CPI is now the headline measure of inflation used for monetary policy. Such undulations in the CPI series create analytical and communication challenges, that can be avoided.

Second, government provides partially subsidised accommodation to its employees by charging less than market rents. While for most of the CPI items, price paid by consumers is taken as price of the item; in case of government housing, change in the level of subsidy (arising from annual increments, promotions or changes in the employees’ remuneration package) is taken as market price.

Third, when pay and allowances are revised under CPC, it is seen that using HRA foregone as a proxy for rent for government dwellings leads to: a spike in housing inflation that percolates through to headline inflation – this is an accumulated price pass through or a statistical blip and not a true change in monthly price; widening of rural-urban inflation divergence, since housing becomes a major driver for CPI and CPI-IW while rural inflation does not have housing component (Annex 2, Chart 2); and attendant concern for the MPC to carefully assess its impact and look through such events.

Fourth, in the years that trail CPC revisions, the above forces work in reverse direction: HRA increase is low and in proportion to the increase in basic pay (about 3 per cent annual increase under the 7th CPC), keeping housing inflation subdued and headline inflation suppressed – this impact too is statistical and not reflective of continual change in prices that market rents provide; and a larger challenge is created for policy makers to measure the suppressed inflation and gauge underlying true inflation.

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Finally, RBI said, "Thus, HRA foregone as a measure of rental price creates distortions in CPI inflation by pushing inflation up during years close to CPC revisions and keeping it suppressed during other times. While on an average over a decade it may appear to be okay, it may still be prudent to address such biases, with plausible solutions."

So, as far as central government employees are concerned,now that you know all this about 7th Pay Commission HRA, next time RBI meet is held, you should catch the central bank's declaration and decode it for how it has affected inflation.