The recently released benign consumer price index (CPI) inflation print, ahead of the Reserve Bank of India’s (RBI) monetary policy review next week, has raised questions on the stark deviation between the actual outcome and the monetary policy committee’s (MPC) expectations of 4.5% average retail inflation in 1HFY18. The MPC’s concern that the pick-up in the pace of remonetization would reverse the distress fall in perishable food items has clearly not crystallized. Moreover, the seasonal uptick in food prices witnessed in the summer months has also not been visible in the recent readings. Instead, prices of heavyweight items like cereals, protein-rich items and processed food have remained significantly benign. Cereals prices in April fell 0.2% month-on-month (m-o-m) compared to the last six years’ April average of 0.1%. Prices of meat and fish increased 0.3% m-o-m compared to the historical April average of 1%. Prepared meals, another heavy weight, increased only 0.1% m-o-m compared to the historical April average of 0.7% and the FY17 average of 0.5%. Across the food basket, the internals look quite favourable, pointing towards a benign trajectory in the next few months.
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Further, the notoriously sticky core inflation, as pointed out by RBI in the February policy while changing its stance from accommodative to neutral, has slid 52 basis points since the recent peak of 4.95% seen in January. From an average of 4.7% in FY17, core inflation eased to 4.43% in April. Even on a sequential basis, the core inflation inched merely 0.2% m-o-m higher compared to the FY17 average of 0.4%. Moreover, if we look at the ‘refined core’ inflation (core inflation excluding petrol, diesel, gold and silver), a measure to correctly gauge the underlying price pressures, the trends look quite benign. Refined core inflation fell to 4% in April compared to the FY17 average of 4.5%.
One basis point is one-hundredth of a percentage point.
Discussing these underlying trends become important given that RBI in its April policy had outlined an inflation trajectory with 1QFY18 ending at around 4% (according to the fan chart). This seems to be significantly higher than the expected actual outcome of 2.3%. Higher inflation projections by RBI probably set the tone for the outrageously hawkish rhetoric from a few MPC members in the previous meeting. The next few readings look to be closer to the lower end of MPC’s inflation target band of 2%-6%. Overall, MPC’s expectation of inflation averaging around 4.5% in 1HFY18 is likely to be significantly undershot. Also, while our inflation reading in 2HFY18 heads north towards 4.5%, by March 2018 (excluding the impact of the Seventh Central Pay Commission’s recommendation on house rent allowance, or HRA), it is still likely to significantly undershoot RBI’s average estimate of 5%.
Notably, RBI has missed its inflation estimates consistently since it started targeting inflation and more so by a huge margin (100-150bps). If such glaring forecast errors become a norm, it poses a risk of negative effect on expectation setting in an inflation-targeting framework. In this context, we expect MPC members to reassess its communication and acknowledge the significant downward bias to its estimates. The global conditions have remained benign, with commodity prices and reflationary risks being under check. Even as goods and services tax (GST) and Seventh Pay Commission related uncertainties still exist, the probability of occurrence of El Niño has been receding, providing significant relief. Moreover, the sequential uptick in perishable food prices has also not emerged in the summer months, pointing towards controlled food inflation. Having seen a sharp downside to the first half inflation trajectory, MPC’s average inflation projection of 5% in 2HFY18 also looks overly stated given that the impact of Seventh Pay Commission-related HRA has been excluded in their projections.
While we expect MPC’s guidance to be slightly dovish, noting a downside risk to their inflation projection, RBI is also likely to maintain its focus on 2HFY18 risks emanating from price distortions due to implementation issues under GST in the near term and the house rent allowance impact. The MPC may be in a difficult spot given the tough stance revealed by few members in the minutes of the previous meeting. While we continue to maintain that a pause is likely in the upcoming meeting, it would be interesting to see how MPC responds to the significantly lower inflation trajectory, especially when output gap is not expected to narrow quickly. However, it seems more certain that this meeting may witness a start of the divergence in the voting pattern within the MPC, the flash images of which were already visible in the previous minutes.
Upasana Bhardwaj is the vice-president and chief economist at Kotak Mahindra Bank.
This is the second in a three-column series ahead of RBI’s second bimonthly policy meeting of 2017-18 on 6-7 June.