For consumer inflation, yesterday’s tailwinds have become today’s headwinds. If imported inflation helped lower the consumer price index (CPI)-based inflation to an average 3.6% last fiscal from 9.9% in 2013—of course helped also by a prudent government stance on minimum support prices (MSPs) and the Reserve Bank of India’s (RBI) inflation-targeting framework—it is stoking it now. CPI inflation flared up to 4.9% in May, fuelled by rising prices of imported crude. In this context, segregating inflation components into pro-cyclical and acyclical parts, and analysing their movement, is revelatory indeed.

Pro-cyclical components are those that typically move with economic cycles. For instance, when growth picks up, incomes rise and drive up consumer demand. As that happens, sectors with relatively high income elasticity see greater demand. As supply takes time to catch up, prices rise. Acyclicals are mostly exogenous and do not move with the economic cycle, such as prices of food, fuel and healthcare. However, if inflationary pressures from acyclicals become persistent in an environment of strong demand, they can become generalized over time.

Last fiscal, acyclical inflation stood at 2.9%, diving from 4.6% in fiscal 2016. Pro-cyclical inflation, in contrast, was relatively stubborn and fell from 5.3% to 4.6%. What restricted the fall was upward revisions in the house rent allowance (HRA) of government employees, which kept housing inflation elevated. This fiscal, we expect acyclical factors—in particular, food and fuel—to drive up inflation, while pro-cyclicals could continue to remain stubborn if growth momentum is strong.

Acyclicals could pinch more

Among acyclicals, risk from higher crude prices is currently playing out, while that from higher food prices is lurking and can materialize should the government raise MSPs and guarantee them to farmers. In recent years, while pro-cyclical inflation has softened, it has been fairly rigid. That was in sync with India’s gross domestic product (GDP) growth, which fell from 7.1% to 6.7%. The pricing power of manufacturers weakened as domestic demand conditions stayed subdued and swathes of capacities went unutilized. The inflation rates of all pro-cyclical components, except housing, saw a fall. The impact of the revision in HRA, which had pushed up inflation last fiscal, is expected to taper off gradually, but other components could swing north. Consequently, the gradual pick-up in demand and utilization would not be enough to sate these capacities. Pricing power, therefore, could stay restrained.

What then for monetary policy?

The RBI’s monetary policy committee has acknowledged the upside risks to inflation. Indeed, its decision to raise the policy—or repo—rate on 6 June after a protracted pause was driven by a surge in core inflation (which excludes the impact of food and fuel price changes). The worry is that along with the increase in crude prices, other input cost pressures stemming from firmer metal prices and a weaker rupee are forcing manufacturers to pass them on to consumers. The RBI said on 6 June that “…inflation in the transport and communication sub-group accelerated due to the firming up of international crude oil prices, even though the domestic pass-through to petrol and diesel was incomplete".

So, further rate hikes could be at hand if crude prices stay high and threaten to seep into generalized inflation through stronger domestic demand. But a surge in aggregate demand is not expected for now, so that scenario may not unfold anytime soon. Also, rising oil prices will shave growth. The Economic Survey, 2018-19 estimates that a $10 per barrel increase in the price of crude reduces growth by 0.2-0.3 percentage points.

Also, with the adoption of inflation targeting, and the resultant improvement in anchoring of inflation expectations, linkages between exogenous shocks and headline inflation have weakened. True, higher market linkages will bring about larger first-round effects of rising prices on inflation. But studies show transmission of fuel prices (and food, also an exogenous shock) to generalized inflation has reduced in recent years.

Sangyup Choi and others, in a note on “Oil Prices And Inflation Dynamics: Evidence From Advanced And Developing Economies", published by the International Monetary Fund, said that when a central bank commits to holding inflation around a numerical target, it helps anchor inflation expectations, which moderates the impact of oil price shocks on domestic inflation. Research by Ravindra Dholakia and Virinchi Kadiyala (“Changing Dynamics Of Inflation In India"), published in the Economic And Political Weekly in March, also suggests such transmission has weakened. Monetary policy usually plays a limited role in controlling the first-round effects of firming exogenous factors—in the present case, crude prices, a weakening rupee, and the possible impact of MSP announcements on food prices. Its role is to ensure demand conditions remain under control and prevent inflationary pressures from exogenous shocks from morphing into generalized inflation, or the second-round effects.

For now, monetary policy may draw some comfort from the fact that the inflation-targeting framework is helping structurally to rein in inflationary pressures. But it still needs to do what it is always expected to do—stay ahead of the curve.

Dharmakirti Joshi and Dipti Deshpande are, respectively, chief economist and senior economist, CRISIL.

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