BackRBI policy: The danger has not yet passed
Crucial to the food inflation outlook will be the monsoon's performance in August, the spatial distribution and the policy response
Premium
On the surface, inflation risks have abated over the last month. Four weeks ago, oil prices almost touched $115, geopolitical risks in Iraq were rising, the monsoon was 40% below normal, and there was concern that the new government would relax the fiscal stance to stimulate aggregate demand. A month later, the outlook is less ominous. Oil is back at $106, the new government—to its credit—has signalled it will pursue fiscal consolidation with the same vigour as the previous government and, most of all, the rain gods have finally begun to smile. The cumulative rainfall deficit has shrunk to about 23%, there are reports that sowing is picking up, and the Met is more sanguine about rainfall in the all-important month of August.
Furthermore, the impact of tight fiscal and monetary policies has finally begun to reflect in core inflation, which excludes food and fuel prices. Core Consumer Price Index (CPI) prices were essentially flat in June—and even though this likely reflects some overshooting—the quarterly, annualized sequential momentum of core CPI is down to 6.2% from 8.5% last November. Who said core inflation is invariant to monetary and fiscal policy?
These developments have induced many analysts to rush to lower their inflation forecasts. Helped by a favourable base effect, many believe inflation will be in the 5% handle in November and mean-reverting to 6-7% by early 2015. The obvious implication is that enough space will open up for the central bank to decisively ease monetary policy in the coming months.
But let’s all take a deep breath. Just because the trajectory of risks has come down, it doesn’t mean the level of risk is low enough to signal that the danger has passed. Here are a few sobering numbers. First, despite the recent recovery, the monsoon is still 23% below normal, worse than where we were in 2009 at this time (20%), which witnessed the worst drought in 37 years (with a cumulative deficiency of 21%). Consequently, between May and December 2009, food inflation surged from 12% to nearly 20% and core inflation surged from 6% to above 10% (but more about the critical transmission from food to core below).
Ominously, food prices are currently under appreciable pressure. Vegetables prices have surged more than 40% in July and cereals and milk prices have hardened. Even assuming a benign core momentum, the July headline CPI is likely to surge back to the 7.9-8% level, which could come as a shock to markets. And, despite some sequential recovery, sowing of key crops (oilseeds, pulses, coarse cereals) is still 40-60% below normal and 14-38% below 2009. Cumulatively, food prices have sequentially increased 60% of what they did in 2009 between May and July. If this run-rate is sustained, food inflation would be back in the 10-11% range by December-January when the favourable base effect reverses.
Crucial to the food inflation outlook will be the monsoon’s performance in August, the spatial distribution and the policy response. What really hurt the 2009 monsoon was the 27% deficiency in August that crushed sowing that month. So, if the current monsoon recovery extends to August, a repeat of 2009 could yet be avoided. Furthermore, spatial coverage will be critical. Despite all the attention to cereals, the food shock in 2009 was largely centred around pulses and high-protein foods in response to the shortfall in the production of coarse cereals. So all eyes are on states like Rajasthan, Karnataka, Madhya Pradesh and Maharashtra, which are least irrigated and critical to the production of oil seeds, pulses and coarse cereals.
But even if food inflation were to temporarily surge, it is unlikely that the Reserve Bank of India (RBI) will respond unless there is evidence that food inflation spills over into wages and core inflation. And here is where the empirical evidence gets disconcerting. Consistent with a Phillips Curve approach, we find that core CPI is driven both by a measure of slack as well as wage inflation. Wages have independent explanatory power because they are also likely to capture the impact of inflationary expectations. These results are intuitive. But what is new and surprising is that—even after controlling for slack and wages—we find that food inflation has a consistent and large direct impact on core inflation, with a 100 basis point shock to food increasing core inflation by 30-40 basis points after one-two quarters. (One basis point is one-hundredth of a percentage point.)
What’s going on? Why is food affecting core inflation, even after controlling for wages? Our hypothesis is there is a powerful inflationary expectations component that is driving core prices, independent of the wage channel. And these expectations are best proxied/impacted by food inflation. We find that a food shock has the largest and most persistent impact on inflation expectations captured by RBI surveys. And this is perfectly understandable. We buy food and fuel on a daily basis, but only pay school fees twice a year. The former is bound to shape expectations more acutely. Finally, we find a simultaneity between food and wage inflation with each driving the other. Food driving wages through an expectations channel and wages driving food by pushing up agri product costs.
Why is this important? Because there is a sense that with output gaps negative and rural wage inflation moderating, core is on an inexorable decline. But if food prices continue to increase like they have over the last three months, and the estimated transmission from food to core holds, headline inflation could be above 8% by the first quarter of 2015. There is, of course, a big caveat to these econometric findings. They presume part relationships will sustain. But if the policy regime has changed and, therefore, expectations are more anchored, historical transmission mechanisms may not hold (the famed Lucas critique).
That said, the policy implication is clear. The government needs to tackle food inflation on a war footing, releasing stocks of cereals, importing pulses and oilseeds, cracking down on speculative hoarding and transporting food stocks quickly from surplus to deficient areas. And the RBI needs to maintain its anti-inflationary stance to ensure wage pressures remain muted. All told, the need for a complementary policy stance between Delhi and Mumbai could not be greater. We, therefore, expect the RBI to stay on hold next week and carefully monitor these risks, even as it recognizes positive developments on the fisc and acknowledges that risks have abated from a month ago.
The monsoon continues to improve by the day. If the rain goods keep smiling the danger could yet pass. But if the monsoon deficit sustains and/or the policy response is found wanting, the complex interplay between food, wage and core inflation poses real inflation risks. And, if that were to happen, reports of inflation’s demise would be grossly exaggerated.
The author is chief India economist at JPMorgan Chase and Co.
This is the third and last in a series of articles ahead of RBI’s bi-monthly monetary policy review on 5 August.
Unlock a world of Benefits! From insightful newsletters to real-time stock tracking, breaking news and a personalized newsfeed – it's all here, just a click away! Login Now!
