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Photo: Reuters
Photo: Reuters

Old foe core inflation to make matters  worse for  central bank

Since core inflation remains well above 4%, it makes it tough for RBI to keep headline inflation within 2-6% range

India’s economy has seen an unparalleled demand destruction this year because of the pandemic. Policy responses have been directed to limit the damage.

But a drop in demand should also result in a collapse of inflation. After all, low demand drags down prices of goods and services. What then explains the rise in core inflation, the closest gauge of demand? Core inflation, which excludes food and fuel inflation, stood at 5.8% in August. It has been above 4% for the past five months.

One clear reason is the disruption in supply chains. The national lockdown and then regional lockdowns have broken the supply chains that snake through multiple states in the country. Simply put, from manufacturers being unable to procure raw material to sellers being unable to reach the final consumer, the broken links created shortages and added a risk cost to the final product and service’s price.

The core problem
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The core problem

Another link is the informal sector. Considering that a large part of the supply chain is made up of the informal sector, the recovery here would determine how fast core inflation can cool off. This rise in core inflation is now worrying economists. Those at HSBC Securities and Capital Markets (India) Pvt. Ltd expect core inflation to be in the 4.5-5% band for the rest of the year.

But there are some small signs of relief in the core inflation figure. Within core inflation, the rise is largely in gold and silver prices, the fuel price-led rise in transportation costs and alcohol prices. The increase in fuel and alcohol prices can be attributed to the increase in taxes levied on them. That of gold could be attributed to safe haven buying amid the crisis. “Excluding these factors, demand pressure was low at 4.2%," said Emkay Global Financial Services Ltd analysts.

Even so, since core inflation remains well above 4%, it makes it difficult for the Reserve Bank of India (RBI) to bring down headline inflation within the 2-6% mandated flexible target. If core inflation remains elevated, then a fall in overall headline retail inflation is possible only if food inflation drops sharply. While economists expect food inflation to cool off from the 9% level in August, a sharp drop is unlikely. Therefore, most economists have now ruled out more policy rate cuts by RBI in the next meeting.

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