Column: Has the dog begun to bark

Written by Renu Kohli | Updated: Jun 23 2014, 08:22am hrs
The jump in May wholesale price inflation to 6% year-on-year from Aprils 5.2%, and way above the consensus 5.3% estimate, is a nasty surprise. The spike comes from an across-the-board increase in primary products and manufactured goods prices. While food inflation wasnt entirely unanticipated, it is the broad-based increase in core-inflationan indicator of demand pressuresthat causes disquiet. Specifically, core-WPI inflation rose 3.84% year-on-year, 59 bps higher than previous month with a sequential, seasonally-adjusted rate of 0.7%. Further, Marchs headline inflation was revised up 30 bps to 6%; the final core inflation print was corrected by 52 bps, raising it to 4.03% from provisional 3.51%. Going by past trends, it would be reasonable to expect similar adjustments in the interim April-May data points.

What could these price developments portend Has the inflation dog begun to bark once more Or are these a temporary blip

Markets did not react adversely to the inflation surprise. Private sector analysts appear to have veered to the conclusion this could be transient, preferring to wait for further developments for a clearer picture. Further, there isnt as yet any clear association between WPI-core and new CPI-core and, therefore, it seemed prudent to wait further as their focus remains CPI inflation, on which monetary policy is now based.

The Reserve Bank of India (RBI) was, however, quick to react. The very next day, the Governor remarked that the next few quarters would be engaged in combating inflation. The comment aimed to recondition expectations formed earlier around its review statement less than a fortnight ago; these stated that a faster-than-anticipated disinflation, adjusting for base effects, would provide headroom for an easing of the policy stance and that further policy tightening will not be warranted if the economy stayed the course (of CPI inflation).

In the backdrop of a deficient rainfall forecast, the central bank has every reason to be concerned for the inflation shock may not be quite as insignificant. For one, the 6.01% inflation out-turn in May was 70 bps higher than the consensus estimate (5.3%), which allows for any understatement or exaggeration of inflation rates from base abnormality. Add to this a 30 bps correction to the final print. The total shock could be as much as 100 bps or a full percentage point increase. And thats just the headline WPI-inflation rate. Core inflation, which is more relevant from a business-cycle perspective, has been adjusted up 50 bps on average in past few months, so the final print could be well be in the 4.3-4.4% region.

What could be most worrying for RBI are the possible reasons for a reversal in WPI-core inflation, while CPI-core inflation was set along a disinflationary path, consistent with other relevant indicators. Consider the following: the rupee has been stable/appreciating for the last several months with sharp improvements in the current account deficit; international oil prices had remained stable at around $105/bbl (Indian basket); fiscal consolidation much faster than initial estimates (fiscal deficit at 4.5% of GDP was 30 bps lower than budget estimate of 4.8% of GDP); input prices moderating (PMI); food prices have been declining; pressure on wage rate has remained subdued and, above all, lower inflationary expectations.

Then what explains the WPI-core reversal Why was RBI so quick to nudge market focus towards inflation once again Does it worry that it may be just a matter of time before goods price increases spillover to consumer price inflation

These may yet be tentative developments and no firm conclusion can be reached at this point. But some features are noteworthy nonetheless. While the WPI is now irrelevant for monetary policy setting, yet its long-term, close synchronisation with the business cycle cannot be disregarded; it well captures and represents demand-side pressures in the economy. On this metric, there are some indications that a rising core inflation momentum could be a harbinger of an upward trend. Signs of economic activity pick-up include the strong export growth in April-May; rebound in industrial output in March-April; somewhat improved growth in non-oil, non-gold imports; and that manufacturing PMI expanded its fastest in February (52.5), holding steady at 51.3-51.4 over March-May with a broad-based strength across consumer, intermediate and capital goods segments.

On the other hand, input prices, as observed from the PMIs, moderated. The fact that producers regardless chose to raise prices in a severe demand compression environmentboth from fiscal and monetary sidesis telling, whatever be the reasons. There is a view that producers might be simply making up for previous strain upon margins they tolerated so far with some offset from sale volumes, which are also steadily declining for well over a year now; or that their viability is too severely impaired for any further absorption. Either way, that core-inflation momentum is sequentially rising in line with manufacturing activity, as observed from the PMIsthis is just 2 points higher relative to October-December 2013 levelsis remarkable. If the final WPI core-inflation print for May 2014 were to be, say 4.3%, that equals core-WPI inflation in December 2012when the manufacturing PMI averaged 53.8 in October-December 2012 quarterbut in a vastly inferior demand environment wherein business and consumer spending, private and public, are much weaker.

The important question that arises is, of course, about the capacity for economic expansion without inflation crossing tolerance bounds. Is potential output so severely lowered in this period Or are there just too many frictions in the economy straining producer profitability It is early days for a proper assessment.

But if these inflation trends sustain over the next few months along with the cyclical upturn, these questions will come to the fore. The choice then would be a further contraction in output through more demand-compressionfor a lowered potential output means more painful adjustments, or tightening by government, households and firmsor else, higher inflation. If the conflict in trade-offs sharpens, it may even invite revisiting growth and inflation targets. These issues could become central to the debate surrounding inflation then.

Renu Kohli is a New Delhi-based macroeconomist