The MPC has complex signals to decode in its rate-setting review

Repo rate hikes serve no purpose when headline inflation is driven up, as from July, by adverse weather shocks to the supply of perishable foods. Nor is a repo rate reduction called for by present growth prospects, which, although perhaps lower than officially expected, are not dire.

Quick supply-side action by the government helped ease the vegetable shortage caused by unevenly distributed monsoon rains. The July headline rate of 7.44 % fell to 6.83 % in August. September rains redressed the rain deficiency in August, rated the driest in more than a century, and the next Consumer Price Index (CPI) print is expected to be lower. However, area sown to pulses, largely grown on unirrigated land, has seen a fall of 10%. Pulse prices look set to rise, as does the price of rice.

Inflation as it is experienced differs from inflation as measured by the base-weighted CPI. The consumer adjusts to a price hike in any item by switching demand if other close substitutes become relatively cheaper. That happened with vegetables, since supply shocks across vegetables are not synchronized.

Supply shocks in pulses, on the other hand, are more synchronized, and the demand for pulses as a subgroup is price inelastic. With price-inelastic demand, the share of pulses in the current basket (which is what matters for inflation as it is experienced) at a time of rising pulse prices will be much higher than the static weight, which is 2.38%, as against 4.31% for vegetables (excluding potatoes and onions). Unlike highly perishable vegetables, however, pulses can be imported, and at least one variety (masoor, known globally as lentils) is diversely supplied globally.

Even if headline inflation using static base weights trends down, consumers can still feel the pressures of inflation if high prices of some key price-inelastic elements in the food basket shift the weights in consumer demand to those very items. That is why the possible price rise in pulses matters. Rice too, except for subsidized recipients. And there is also a rise in the global price of oil.

None of this calls for immediate rate action by the MPC. Rate actions by other central banks in the world do matter for the external value of the rupee (which impacts domestic inflation), but more than one rate hike in Europe, the UK or US going forward seems unlikely. However, it is hard to be certain, and at the long end, rising bond yields in the US have strengthened the dollar.

The third consideration for the MPC is domestic growth. The first quarter (Q1) of the current year 2023-24 reported real growth of 7.8 % year-on-year. However, these growth estimates were challenged for the implausibility of nominal growth exceeding real growth by just 0.2%. At this juncture, when the Wholesale Price Index (WPI) actually fell 2.9% year-on-year across all goods in Q1 over Q1 of last year, the use of a single deflator largely based on the WPI for both output and inputs implies possible mis-estimation of either real or nominal growth.

It all depends on which of the two aggregates, nominal or real, is estimated first, with the other following from the first. The Q1 GDP estimate lists 12 high-frequency indicators used to arrive at sectoral growth rates. Most of them are physical indicators of volume of activity. These would have been applied to the real aggregate of Q1 of the previous year, with nominal growth derived from that. For those sectors, it is real growth which would stand correctly estimated, and nominal growth possibly underestimated (depending on what mix of WPI and CPI was used).

Taking sectoral growth rates as reported, growth in the financial services sector (financial, real estate and professional services) leads all the rest, at 12.2% over Q1 of the previous year. The indicator used for this sector would be growth of bank credit and deposits, which is at current prices, from which nominal growth would have been generated and real growth obtained therefrom. If the sectoral deflator for this sector was dominated by the WPI, then real service sector growth might well have been overestimated.

Whatever the degree of such overestimation, high-frequency indicators point to the financial sector as today’s foremost driver of growth. The external trade figures display the buoyancy of business service exports, although that will be challenged by sagging global growth. Also, job entrants from the top technical schools are not seeing business services optimism. Add to that the impact of El Niño on rural incomes, and the most recent growth estimate of the ministry of finance at 6.5% could be a little optimistic.

The MPC may stay an even course for now, but has to remain watchful. The global macroeconomic scenario is cloudy and uncertain. For now, core inflation as correctly measured has dropped further from 5.12% in July to 5.06% in August, so that is one hook on which to hang the flat repo hat.