Column: Honey, its not just onions!

Written by Sajjid Z Chinoy | Updated: Oct 18 2013, 09:37am hrs
Heres the good news. A semblance of macroeconomic stability is finally returning to India. The rupee has mean-reverted smartly. The CAD is on course to print well below the governments $70 billion target. And the government is expected to find a wayor make oneto keep to its budgeted fiscal deficit.

These are clearly welcome developments. But just as excessive pessimism was unwarranted mid-year, excessive optimism should be avoided in the Fall. Part of the reason the rupee has strengthened is because there is no oil demand in the market. So, for all intents and purposes, Indias spot FX market is currently like a current account surplus country. And that cannot go on forever. Furthermore, apart from gold, the narrowing of the CAD is largely cyclicalwith the growth gap between India and the rest of the world narrowing. That said, the 11% real depreciation of the currency since May should undoubtedly provide some competitive advantage to Indias exports. Finally, the fiscal consolidation is welcome but the means (draconian expenditure compression at the end of each year) appear unsustainable and will pull down growth in the coming quarters. Instead, at some point, we need true fiscal reforma GST, extending UID and cash transfers to all subsidies. Similarly, the structural drags underpinning the CADcoal, scrap metal and fertiliser imports, iron ore exports, FDI profit repatriationstill need to be addressed. Therefore, recent improvements can be thought of as being on a course of paracetamol to tame the symptoms, and buying time to embark on a needed course of antibiotics.

In contrast to some normalcy on these twin deficit issues, there have been a set of jarring inflation prints. WPI inflation is back up in the 6% handle. And CPI inflation continues to hug the double-digit mark with core CPI rising to 8.4%! But even the uncomfortably high year-on-year prints understate the underlying inflation momentum. This is the fourth consecutive month that headline WPI has increased more than 1% month-on-month (seasonally-adjusted). On a quarterly, annualised basis therefore, WPI inflation is actually running in double digits! Ditto for the CPI.

Yet, the morning after, market and press analysis have focused almost exclusively on the role of onions, in driving the recent inflation uptick! Why is this important Because if you believe inflation pressures are mainly reflecting a temporary supply-shock, policymakers should be expected to see through that. These shocks, by virtue of being a one-off, should affect the price level as opposed to the rate of inflation.

To be sure, onion inflation (not for the first time) has hit the roof, printing at 200%-plus in August, and 300%-plus in September. However, we need to be aware of at least two phenomena. First, onions have a weight of 0.17% (yes!) in the index, so even disproportionally large swings have a relatively limited impact on headline WPI. Second, there are all kinds of base effects at play, so the right measure is to look at the sequential momentum (seasonally-adjusted) of onion inflation and its contribution to that of headline inflation. The accompanying chart shows the three-month on three-month, seasonally-adjusted, annualised momentum of WPI inflation with and without onions. The lines are almost identical! Inclusive of onions, the annualised momentum of headline WPI is 13.7%. Without onions it is 12.4%. Slim comfort! To be sure, the annualised momentum excluding all vegetables falls to 9.5%but this is still a pick-up of 10.5 percentage points over the last 4 months. So even though onion and vegetables make for good headlines, there are more generalised inflation pressures at play.

What are these pressures For starters, food inflation is far more structuralaveraging 12% for the last five years. So there is nothing temporary nor idiosyncratic about it. Instead, it reflects a fundamental mismatch between food demand and supply. A bad monsoon, hoarding, broken supply chains exacerbate the underlying problem. But they should not be used to explain it away. In turn, persistent food inflation is likely contributing to both inflation expectations and wage pressures. Much is made of core versus non-core inflation. Thats understandable for an industrialised country. In developing countries where 50% of ones income can be spent on food, the distinction is largely temporal. If persisted for long enough, todays food inflation is tomorrows wage inflation. And day after tomorrows core inflation.

However, none of this should come as a surprise. Instead, what has surprised some is the extent to which core inflation momentum has risen. While year-on-year WPI core inflation appears relatively benign at 2.1%, it conceals the fact that core prices have risen sharply on a sequential basis for two of the last three months. On a quarterly basis, the annualised momentum has risen to 5.5% in September from a negative momentum in May. And the core pressures are across the board with a sharp rise in the momentum of textiles, chemicals, base-metals to name a few. These tendencies are more accentuated in the CPI with core prices rising nearly 1% sequentially for the last four months. But if growth momentum is so weak and output gaps so negative, why is core rising at this pace We suspect this likely reflects multiple forces:

First, firms have taken a significant margin compression over the last year. Against that backdrop, the 12% FX depreciation has sharply pushed up input costs and, in many cases, left firms with little choice but to pass it on downstream.

Second, there are some signs of an industrial pick-up, with manufacturing exports increasing sharply for three successive months and signs that rural demand maybe lifting. This has likely increased pricing power at the margin, and if rural demand picks up more broadly after the strong monsoon, pricing power could rise some more.

Finally, and more worryingly, with inflation expectations getting so deeply entrenched, the role of slack in driving inflationary dynamics could be reducing (i.e. Indias Phillips curve is getting flatter)!

The weaker rupee has directly pushed up input prices (fuel, non-food primary articles) and thereby contributed to higher core inflation.

But now that the rupee has stabilised, isnt this over Not necessarily. Past experience has shown that, given the menu costs incurred in increasing prices, the full impact of the FX passthrough could be staggered over several months. In response to the FX shocks in August 2011 and May 2012, the momentum of core inflation subsequently rose for 5-6 months in each case. Also remember, there is no oil demand in the market, so current FX levels can be thought of as slightly artificial.

All told, the nasty inflation surprises over the last two months reflect both structural food inflation and the weaker FX. They say, getting the diagnosis right is half the cure. Onions make for good newspaper headlines. But blaming them for all our inflation woes would be a misreading of the data.

The author is senior South Asia economist at JP Morgan