Home / Opinion / Columns /  There's not much to worry about inflation in 2021

For investors figuring out real returns on their investments by tracking CPI inflation, there is a seemingly confounding trend: inflation is easing, and prices of items such as petrol and diesel are moving upwards. CPI inflation data read 7.61% in October; it eased somewhat to 6.93% in November and dropped significantly to 4.59% in December. In January, it eased further to 4.06%. On the other hand, the money circulation level in the economy is on the higher side now, higher than pre-demonetization levels. Global crude oil prices are looking upward, and pump prices of petrol/diesel are the talk of the town.

Amid these conflicting trends, what is the projection? The RBI is projecting inflation at 5% or a little north of 5% till September. Net-net, the RBI is calling for much lower inflation in 2021 than in 2020. In 2020, average CPI inflation was 6.63%. The forecast is based on certain assumptions, e.g., USD-INR level, food prices, crude oil prices, commodity prices, etc. and there may be negative surprises if these levels are adverse than expected. Even then, it is expected that inflation will average palpably lower than 6.63% of 2020. Now, let’s demystify what is happening.

Inflation is measured on a basket of items with weightages assigned. Obviously, what is happening to goods and services with a higher weightage will have a higher bearing on the ultimate inflation number we see, which is referred to as headline inflation. In this basket, almost half is dedicated to food or food-related items. The weightage is 48.24% to be precise, with sub-items like cereals/products 9.7%, milk/products 6.6%, vegetables 6%, meat and fish 3.6%, oils/fats 3.5% and many other sub-items.

Throughout 2020, the supply of food or food-related items was disrupted. Though the government allowed the movement of essential items in the lockdown phase, the ecosystem was disturbed. The point is to say, if logistics and supply comprising half the basket of inflation is disrupted, inflation would be pushed upward. Now that things are normalizing and supply channels are functioning, it is having a soothing effect.

On the other hand, there is no direct weightage assigned to crude oil/petrol/diesel; there is 8.59% weightage for ‘transport and communication’. While petrol/diesel would have an impact here, there are a host of other items in this sub-basket. For example, a train journey or telephonic communication would not be directly impacted by petrol/diesel prices. There is no weightage assigned to commodities like steel or aluminium or copper.

Another key component of inflation measurement is “base effect". Inflation is measured by comparing the inflation index for the current month with that of the corresponding month in the previous year. As an illustration, the inflation index for January 2021 is 156.3, which is compared with that of January 2020, which is 150.2. The output is (156.3 - 150.2) divided by 150.2 = 4.06%. If inflation was high in the previous year and the index for measurement was relatively higher, it is known as positive base effect. This contributes to lower inflation because even at similar price levels this year, inflation as we see it comes down.

For December 2020, there was a significantly positive base effect in the form of relatively higher inflation index in December 2019. This contributed to inflation coming down to 4.59% in December 2020 from 6.93% in November 2020, apart from easing price levels. Going forward, from January to March 2021, the base effect is flat to negative. The implication is, inflation coming down to 4.06% in January 2021 is due to easing prices. Beyond March 2021, the base effect is favourable, which will contribute to tempering headline inflation.

Some of the other components of the inflation basket are housing with a weightage of 10%, fuel and light 6.8%, health 5.9%, education 4.5%, personal care and effects 3.9%, household goods and services 3.8%, etc. Apart from transport and communication, these are expected to be easy going forward, unless there is another wave of disruption. In sum, your benchmarking for measurement of real returns would be relatively softer this year.

Joydeep Sen is a corporate trainer (debt markets) and author.

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