A sharp fall in both retail and wholesale inflation has raised the stakes for a rate cut by the Reserve Bank of India (RBI) in its next monetary policy review. Both WPI and CPI inflation fell to 2.2% in May, on the back of a sharp decline in food prices. We are living in interesting times. India’s macro numbers have puzzled economists and policy-makers equally. Considerable growth slowdown to 6.1% in Q4FY17 and benign inflation trajectory since November last year (average 3.3%) has not translated into an interest rate cut by the central bank. RBI Deputy Governor Viral Acharya pointed out that the recent inflation and growth numbers have raised “difficult policy questions” and, based on the next few months’ data, RBI can “act for a broader accommodation through the interest rate policy.”
So, what’s the reason behind an overcautious RBI?
The moderation of CPI inflation to 3% in April and further to 2.2% in May 2017 has led the market to question RBI’s monetary policy stance and its inflation forecasts. In the absence of any policy interventions and persistence of April trends, RBI projects inflation in the range of 2-3.5% and H2FY18 to 3.5-4.5%, amidst growing criticism of consistently overestimating inflation. The central bank has expressed caution stating that the recent developments in inflation could be transient and sights rural wage growth, fiscal slippage, farm loan waiver, Seventh Pay Commission allowances as upside risks to inflation. Given RBI’s policy explanation, one needs to be mindful of two interesting observations emerging out of the latest inflation trajectory—both at consumer as well as wholesale price level.
You May Also Like To Watch:
First, a simple dissection of the retail (CPI) headline numbers is quite intriguing. Food inflation has averaged 1.1% since November 2016, contributing the most to headline CPI disinflation. Core CPI inflation has also moderated from 5% in October 2016 to 4.1% in May. Within food, it is the deflation only in two categories—pulses and vegetables—that has led to such a sharp slowdown in food inflation. Both categories contribute around 8% to inflation basket by weight. Thus, even though the May print shows food price deflation (-0.1%), food inflation excluding vegetables and pulses grew at 3.8%. Food inflation excluding vegetables and pulses has averaged 4.9% since November. Vegetable inflation is highly cyclical and any short-term disruptions to the food supply chain impacts food inflation. The current deflation in pulses is more of a correction in a sharp rise in the price of pulses seen in FY16 and H1FY17, thanks to record output and imports. Any firming up in food prices, especially vegetables, will impact headline number.
Food inflation becomes extremely critical in estimating headline numbers, given its huge weight (46%) in the CPI basket. Forecasting food inflation, especially volatile components like vegetables, pulses, etc, has never been easy. Probably this is where most economists, including RBI, have gone wrong in estimating the inflation trajectory. This also explains RBI’s wait-and-watch policy.
But does this mean RBI should be wary of cutting rates in the future?
This brings us to our second observation—the divergent trends in different price level indicators—CPI and WPI. Chief Economic Advisor Arvind Subramanian has often pointed out that, in normal times, the inflation target/objective should be based on CPI. But when different price indicators are moving in diametrically opposite directions, the monetary policy reaction function may vary. In fact, for monetary transmission to work, both consumer and producer prices are relevant.
So, how has the new WPI series behaved vis-à-vis CPI?
India’s new WPI series (base 2011-12) excludes indirect taxes while compiling indices of manufactured products. This ensures that price signals emerging from production side of the economy are not influenced by the fiscal policy. Therefore, the new series of WPI is conceptually closer to the concept of Producer Price Index (PPI), which is a reflection of the average prices that producers receive. What’s interesting is the diametrically opposite trajectory of core CPI and core WPI (non-food manufacturing WPI). While core CPI has dipped 100 basis points (bps) since November 2016, core WPI has risen by 200 bps during the same period. This is broadly in line with the increase in global commodity prices over the past one year, which would translate into increased input costs.
This recent trend contrasts with the earlier trend of falling input costs and sticky core inflation (retail) in FY16. The divergence in price indicators could also possibly explain the sharp slowdown in growth in the recent quarter. With the GDP deflator biased in its weight towards WPI, high WPI could have underestimated growth in Q4FY17 and overestimated the same in the previous quarters. Rising producer price inflation and declining consumer price inflation indicate that producers are not being able to pass on the increase in input costs to the consumer and their margins are being compressed. In a scenario of low capacity utilisation, this would further hurt new investment. If the central bank policy continues to remain hawkish with respect to its CPI target and the divergence between producer and consumer prices continue, this may ultimately hurt growth—both at the consumer’s as well as at the producer’s end. Therefore, a single-minded pursuit to bring down the headline CPI number by maintaining high interest rates might prove to be counterproductive.
Previously also we have argued (“Time right for Urjit Patel led RBI to cut interest rates; here’s why” FE, March 17; https://goo.gl/ob6Nqy) how higher interest costs have hurt corporates, especially small and medium enterprises. Thus, the Monetary Policy Committee (MPC) needs to be mindful of price indicators both at the consumer as well as the producer level over the next few months before its next monetary policy review.