Too early to declare victory on inflation

In the aftermath of demonetisation, both food price and core inflation measures continue to slow. Average CPI inflation looks set to undershoot the Reserve Bank of India’s (RBI) projection of 4.5% in the first half of 2017-18. Does this call for a shift in policy stance and monetary policy easing by RBI? Not really. There are five reasons why caution is still warranted.

First, one of the main reasons for recent low inflation numbers is lower-than-expected food price inflation. It is true that proactive food management by the government and prudent support price policies have led to a lowering of food price inflation and its volatility. In 2015-16, food price inflation averaged 5.2% year-on-year (y-o-y) versus 9.6% in 2012-14. But the recent trend in food price inflation reflects more the initial distress sales in perishables during demonetisation and improved supply, especially in the case of pulses.

In April 2017, food price inflation stood at 0.6% y-o-y, vegetable price inflation at -8.6% and pulses price inflation at -15.9%. This is not a new normal. Rural agriculture wages rose 8.1% y-o-y in March 2017 and the weighted average minimum support price increase was around 6% in 2016-17. Hence, even if food price inflation reverts back to its 2015-16 average of 5%, this could add 1.7 percentage points to headline inflation.

Second, core inflation has moderated. There are many methods of measuring core inflation; our preferred gauge is the 10% trimmed mean, which excludes 10% each of the highest and lowest CPI inflation components each month. We find that trimmed mean inflation was broadly stable in the 4.5-5.0% range until October 2016, but it started to moderate after demonetisation and stood at 4.1% y-o-y in April 2017. If the downtrend was triggered by demonetisation, then won’t re-monetization reverse the downtrend, albeit with a lag?

Moreover, it is hard to disentangle the role of structural from cyclical factors. Some of the moderation is possibly structural as seen in disinflation in non-discretionary categories such as health services. But the negative output gap and stressed balance sheets have also played a large cyclical role. If these cyclical drivers reverse, will inflation still stay at 4% sustainably?

Third, an important aspect of the flexible inflation-targeting regime is the need to lower households’ inflation expectations. Even as CPI inflation moderated to around 3.5% y-o-y in Q1 of 2017, one-year ahead inflation expectations rose to 9.3%. Now, expectations are known to be adaptive. Our analysis suggests that the sensitivity of expectations to actual inflation is the highest at a five-quarter lag with both food and oil prices playing important roles in their formation.

This implies that if the current regime of low headline and food price inflation persists, then inflationary expectations should moderate in the coming quarters. But policymakers need to wait out this process. One-year ahead inflation expectations have fallen from their peak of 13% in 2013, but they are still much higher than in 2006 (5.5-6%).

Fourth, there are triggers on the horizon that may result in a one-time rise in inflation later this year. The house rent allowance (HRA) increase for central and state government employees is still pending. The near-term inflation impact of the coming goods and services tax (GST) is not yet certain. Even as the government has tried to ensure that the GST is progressive and results in disinflation, this may not practically materialize due to firms’ asymmetric pricing responses, which tend to be rigid on the downside and more flexible on the upside. Other factors like difficulties in isolating the profits accruing due to GST suggest that while direct benefits may be passed, the indirect benefits may be fully retained by most firms.

Indeed, international evidence suggests caution. We studied the impact of GST on near-term inflation in Australia, Canada, Japan, Malaysia and Singapore. We found that even as the GST tax rate was introduced at a rate lower than previous tax rates, inflation rose in all five after GST implementation, including in Malaysia, which tried to more strictly enforce anti-profiteering mechanism.

Fifth, caution is also warranted due to global factors. A gradual reduction in the Fed’s balance sheet and potentially even by the European Central Bank next year could result in higher longer-term rates globally and trigger capital outflows from emerging markets. India has a sufficient cushion on this front—higher real interest rate and strong fundamentals—but policymakers still need to stay alert.

Overall, though headline inflation has moderated and will stay benign in the next few months, it is best to exercise caution now. Rather than ease in haste and reverse course later, it is prudent for policymakers to stay the course and ensure that the recently made gains are indeed more durable.

Sonal Varma is managing director and chief India economist, Nomura.

This is the first in a three-column series ahead of RBI’s second bimonthly policy meeting of 2017-18 on 7 June.