Reading beyond the inflation euphoria
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There is a general sense of euphoria on consumer price index (CPI-Combined) coming in at a new low of 2.99% for April, down from the March number of 3.89%, mainly on account of lower food inflation and the base effect. The observed values present a downward trajectory and show inflation to be benign. However, beneath the surface, the inflation outlook has many pressure points in the near term, notably the continued elevated inflation expectations, the non-generalized nature of headline inflation and the persistence of inflation excluding food and fuel.
The wholesale price index (WPI) inflation numbers came with a base revision and enhanced coverage, both of which are welcome. But the common thread running through both the consumer price index (CPI) and WPI measures is that headline inflation excluding food and fuel has been sticky. All of these point to symptoms that can present challenges in keeping inflation within the upper band of 6% under the flexible inflation targeting framework, which targets CPI-Combined to be at an average of 4% (plus or minus two percentage points.
The challenges can be seen from the adaptive inflation expectations of households in the Reserve Bank of India’s (RBI’s) survey of March 2017, which remained at an elevated level. Inflation expectations looking ahead to the three-month period and the one-year period were 7.5% and 8.8%, respectively. The inflation expectations came in at a level higher than the observed inflation rate for 2016-17 and also the baseline forecast rate of the RBI for 2017-18, i.e. an average 4.5% in the first half and 5% in the second half. More than that, as the last monetary policy report of the RBI observed, the “proportion of respondents expecting the general price level to increase by more than the current rate also edged higher”.
This comes along with a high level of uncertainty in crude oil prices, upside pressure from the implementation of the house rent allowances under the 7th Central Pay Commission (CPC) and an emerging (albeit one-off) challenge from the introduction of the goods and services tax (GST) in 2017-18. As the country evidence suggests, the introduction of value-added tax has the potential of some upside risks to the inflation. In a report released last Friday, the RBI notes that there are “short-term costs in terms of the pass-through of GST to inflation” (though it also points out in brackets that nearly 50% of the CPI is outside the ambit of GST).
The RBI’s April 2017 monetary policy report has detailed the magnitude of upside risks. It says that if crude rises to $60 per barrel, the inflation rate would be higher by 30 basis points (bps) compared to the baseline scenario. Second, there is pressure on headline inflation from higher domestic demand coupled with imported inflation from higher global commodity prices. The RBI report assumes a 10 bps increase in inflation with a global growth increase of 50 bps and the resulting domestic growth increase of 25 bps.
Third, the housing inflation emanating from the implementation of the pay commission house rent allowances both by the Centre and states could result in a rise of 100-150 bps in the headline inflation.
Fourth, the risk of possible El Niño effects taking a toll on the monsoon still remain, and if this leads to the downward growth of agricultural output and allied activities by one percentage point, the impact on headline inflation would be 30 bps above the baseline. There could be some downside risks too from these sources if the assumptions do not validate themselves. But there is a strong possibility that the balance of risks has a higher weight for upside rather than the downside.
Moreover, the deceleration in headline inflation rate is not generalized. Mostly, the deceleration is food-centric, caused by the demonetisation effect of distressed sale of perishable goods by farmers coupled with lower demand due to wage shocks. The RBI has described it as an “abrupt compression in food inflation”. Non-food inflation has remained sticky and will continue to be stubborn, showing downward inflexibility.
This is because cost push pressures are emerging due to escalated manufacturing input costs. It is pertinent to note that as per the empirical finding of the Central Statistical Organization (taking into account 140 products and 66 industries), a 1% increase in crude oil, metals and coal price could result in an increase in headline CPI inflation by 6 bps, 7 bps and 2 bps, respectively.
According to the RBI’s industrial outlook survey, most of the firms expect to pass on the higher input costs to the selling price. Concomitantly, the output price inflation will be higher.
Thus, even though the headline inflation is on a disinflationary path, the inflation excluding food and fuel (core inflation) remains inexorable. In this light, the RBI needs to re-anchor inflation expectations.
There is merit in the observations of the monetary policy committee member and RBI executive director M.D. Patra, (who incidentally is the only career central banker among the committee members) favouring a pre-emptive strike of 25 bps increase in policy rate. This may not happen but going the other side to lower the rates, too, would not be warranted at this time. The Billion Press
R.K. Pattnaik and Jagdish Rattanani are, respectively, professor, SPJIMR and editor, SPJIMR.