Graphic: Ahmed Raza Khan/Mint
Graphic: Ahmed Raza Khan/Mint

The lurking threat of inflation

There is too much complacency over the medium-term inflation outlook owing to its significant decline in the past

Now that the deluge of assessments about Prime Minister Narendra Modi’s two years in power has subsided, it is constructive to focus on a key issue: India’s inflation outlook. Depending on how it is handled, it could have significant positive or negative repercussions, both economic and political.

There is a high degree of complacency over the medium-term consumer price index (CPI) inflation outlook, in my view. This conclusion acknowledges the significant decline in inflation in the past two-and-a-half years. It is also mindful of some favourable impact on inflation in the near term, if the monsoon is above normal.

The typical narrative about India’s inflation is that it has been tamed. This is incorrect, in my opinion. To be sure, inflation has fallen meaningfully, to 5.4% in April 2016 from 11.5% in November 2013. Also, inflation rates in both food and core (i.e. non-food and non-fuel) components have come off impressively from their respective peaks. The past, however, is no indication of future performance. Three key questions need to be answered in order to assess whether India has properly nipped the threat of inflation.

First, is the fall in CPI inflation sufficient? The answer is contained in the Reserve Bank of India’s clarity on the inflation glide path in the context of its transparent flexible inflation-targeting framework. Volatility aside, inflation outcomes have been better than the guidance of 8% for January 2015 (actual: 5.2%) and 6% for January 2016 (actual: 5.7%). However, the decline in headline CPI inflation is still insufficient. This is because RBI aims to bring inflation down to 5.3% in Q1 2017 and to around 4% in Q1 2018. The latter goal is ambitious.

Second, is the decline in inflation sustainable? That doesn’t mean whether inflation will be well-behaved in the next few months. It means inflation needs to be at least in line with the RBI’s guidance even when aggregate demand picks up and corporate pricing power returns. Such an outcome appears unlikely, though all is still not lost.

A confluence of favourable factors has flattered India’s inflation in recent years. Barring unforeseen circumstances, the mix of these factors will become less favourable as growth picks up. This will increase concerns about the medium-term inflation outlook, even if one is less worried about inflation in the near term.

The most important factors favourably affecting inflation were the collapse in the international prices of commodities, especially crude oil and food, weak domestic corporate pricing power, and the government’s welcome discipline on minimum support prices.

The firming of core CPI inflation, to 4.9% in April 2016 despite the still-subdued aggregate demand and weak corporate pricing is worrying. The rigidity in core inflation is driven mainly by higher inflation in service sectors, including education and health. These sectors have chronic excess demand that is unlikely to change given the demographic and increasingly aspirational profiles of our population. However, the government still hasn’t effectively addressed them.

The risks from the 77% surge in crude oil prices from their January low and the still-missing institutional reforms for ensuring sustained low volatility in food inflation shouldn’t be dismissed. The first is problematic because even if oil prices don’t rise significantly from here on, their favourable impact on inflation will progressively dissipate and then likely reverse. The second is in the government’s control but not much has been implemented to boost confidence that inflation can decline even when growth accelerates.

On food inflation generally, few fully appreciate that the Modi government inherited outsized stock of cereals. A part of these were released into the market to ensure their prices did not spike because of poor monsoon. The starting point of relevant stocks explains in large part why cereal inflation has been well managed but not the inflation in pulses.

Finally, should policymakers be worried about the recent signals from wholesale price index (WPI) inflation? The answer is an emphatic “yes". WPI inflation in April came in at 0.3% y-o-y, the first positive print in a year-and-a-half. It was driven mainly by higher food inflation and the rebound in commodity prices. CPI inflation did not benefit much from the negative WPI inflation from late 2014 (see chart 1). This is because of the composition of the two inflation yardsticks with respect to food, fuel-related items and services inflation, and structural rigidities that kept retail inflation sticky. CPI-core inflation has been edging up (see chart 2), and WPI-core inflation will probably turn positive in the next month or two.

Given that the RBI’s policy is centred on CPI inflation, WPI inflation isn’t important for decisions on policy rates. However, the signals from input prices and tradables inflation captured in WPI offer useful clues about the potential risks to retail inflation. Frankly, there is no guarantee that higher WPI inflation won’t have any adverse impact on retail inflation. After all, private consumption will be boosted by the implementation of the pay commission recommendations and a favourable monsoon. The acceleration in private consumption growth in a supply constrained economy increases the likelihood of some pass-through of higher WPI inflation to retail inflation.

Lower trend inflation as guided by RBI can create room for a significant structural decline in interest rates, which in turn will boost growth. The onus is on the government to fix the structural impediments to ensure low and stable inflation over the medium term. Actions so far have been disappointing. And time is running out.

Rajeev Malik is a senior economist at CLSA, Singapore. These are his personal views.

Comments are welcome at theirview@livemint.com

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