The main measures of Indian inflation sometimes tend to wander off in different directions. We are at one such confusing moment. This has implications for the Monetary Policy Committee that decides the pivotal interest rate for the Indian economy.
Here are the bare numbers. Consumer price inflation has been inching up for the past eight months. It is likely to continue to do so over the next few months as well. The latest reading was 4.45% in July, the highest in 19 months. However, it is not too far from the average monthly inflation over the past five years.
Also, it is only marginally higher than the level that the Reserve Bank of India (RBI) targets and is well within the broader inflation range that the central bank is expected to operate within.
Then there is core inflation, which measures price pressures after removing the cost of items such as food and energy in household budgets. Its level is often interpreted as a gauge of demand in the economy. Core inflation too has been rising, but is still below the headline number. It was around 3.9% in July—and even lower in case an increase in the prices of precious metals such as gold and silver are taken out of the calculation.
The third measure is wholesale price inflation. It is heavily weighted in favour of primary articles, fuel and manufactured inputs, so it reacts fast and hard to supply disruptions such as a bad monsoon, an oil-price spike or any other global commodity shock.
The rate of increase of wholesale prices is close to double digits, or broadly more than twice as high as the other two measures. (The producer price index, which is still too new to be used for economic analysis, is at a similar altitude.)
The analytical puzzle is to figure out what happens next. If the three main measures of Indian inflation are at different levels, how will they converge in the coming months? Will they all be pulled towards the level of core inflation, headline consumer price inflation or wholesale price inflation?
Much depends on whether the price shocks in a few goods, services or commodities diffuses across the rest of the economy through a series of second-round effects that eventually lead to generalized inflation.
A spike in the price of oil, wheat or crude oil does not automatically become economy-wide inflation. It becomes broad-based through specific channels, and knowing which one is operating tells you whether the shock will pass or persist.
The first channel is mechanical. Crude oil is used in transport, plastics, fertilizer, food—nearly everything. When its price rises, costs rise across the economy, and firms pass this on to consumers though with a lag. This commodity’s place in the input-output matrix does the work on its own.
The second channel runs through wages. If the commodity is a large part of what households buy, headline inflation rises directly. Workers then bargain to protect their real incomes. Wages rise, costs rise again, and a second round of price increases follows, assuming that workers have adequate bargaining power to protect their earnings against rising inflation.
The third channel is of expectations. A shock that is salient enough can shift what people believe about future inflation. It can be the cost of sugar as much as the cost of petrol. Firms raise prices in advance. Workers demand raises in advance. Traders begin to hoard. This is the channel that modern central banks fear the most. It is what turns a limited price shock into something durable.
The distinction that matters in the end is between first-round and second-round effects. The first round is pure arithmetic based on the weight of a particular item in the relevant price index. The second round is a more complex phenomenon since it deals with spirals, expectations, psychology and accommodation. This is the backdrop against which a temporary shock turns into generalized inflation.
How policymakers read the tea leaves is very important. So is the credibility of the central bank. Participants in the economy may be ready to look past a temporary spike in the prices of a few items so long as they are confident that the central bank will keep overall consumer price inflation close to its mandated target.
There has been a growing body of empirical evidence that wholesale inflation tends to move towards consumer inflation during episodes of divergence. And headline consumer price inflation moves towards core inflation when there is a substantial gap between the two.
The upshot is that participants in the economy have been more prepared than before to look past sudden supply shocks that push up prices of individual commodities. That is testimony to the stock of credibility gained by RBI over the past decade on the inflation- control front.
Even now, despite signs of rising inflationary pressures, there is only slim evidence that price pressures are diffusing through the economy.
However, the Indian central bank will have to stay alert to signals from product markets, the country’s labour market and also commodity markets of that behaviour changing to an extent that inflation in a few items could spill over to the rest of the economy.
The author is executive director at Artha India Research Advisors.