The latest CPI inflation came in at 5%, the lowest in the fiscal so far. Does this give us a reason to cheer? May be not. Inflation fell from 6.1% in July 2016 to 5% in August, but the fall doesn’t seem to be broad based. Food accounted for almost 94% of the disinflation. Further, vegetables alone accounted for around 77% of the fall. Despite its declining trend over the last two years, retail inflation has been playing a sort of hide and seek with the consumers.
Average CPI inflation fell from 9.4% in FY14 to 4.9% in FY16. Five categories—cereals, vegetables, housing, fuel and light and transport and communication—which account for about 40% of the CPI basket have contributed almost 80% to the disinflation since FY14. Mainly, cereals and vegetables contributed 57% to the overall headline disinflation.
In the previous article Inflation: No room for complacency (FE, January 5) we had highlighted that, “the short-term volatility in inflation and the disinflationary trends has been driven more by food and fuel pressures, while demand-driven inflation has remained relatively sticky. Thus, this may very well be the end of India’s deflationary cycle giving the RBI lesser room to cut rates. Retail inflation has clocked an average of 5.5% (y-o-y) in H1 2016 and reached its 24-month high of 6.1% in July.
The government notified an inflation target of 4% +/-2% for the next five years until March 2021. While the government’s decision to stick to the recommendation given by RBI is welcome, what this also means is that inflation cannot remain above 6% for a sustained period of time. Thus, the task ahead for the new RBI governor will not be easy as upside pressures on inflation far outweigh the downside ones.
The inflationary/disinflationary trend in India over the past few years has been on account of a few categories. It’s primarily driven by food and fuel prices. The central bank’s monetary policy targets core inflation (inflation reflective of demand side pressures, which is not affected much by supply side shocks).
To compute core inflation, we exclude food, fuel and light from headline numbers. Core inflation has in fact risen from an average of 4.4% in 2015, to 4.7% during the first eight months of 2016. To completely exclude the impact of supply side shocks on inflation, we also exclude transport and communication (impacted by movements in global oil prices). We call this category Core ex-TnC. Core ex-TnC has in fact remained sticky at around 5.5% since November 2014.
Assuming core CPI remains around 5% level, for overall CPI to be close to RBI’s target of 4%, non-core CPI will have to be around 3.5%. This seems to be a difficult target to achieve. Even if we were to take the upper limit of the overall CPI target—6%, non-core CPI cannot be allowed to go beyond 7%.
Various state governments are already in the process of implementing the Seventh Pay Commission recommendations with arrears effective from January 2016. Basic salaries will increase 2.57 times in August for one crore government employees.
The house rent allowance (HRA) hike has been deferred for now, but it could lead to higher inflation in the next few months once implemented. This may put some upward pressure on an already sticky core inflation, due to increase in discretionary spending.
Further, likely GST implementation in 2017 will lead to further uptick in inflation. The GST rate is unknown as of now. Expectation is that the standard rate will be 18%, along with a merit rate on essentials and a demerit rate on luxury cars, tobacco, etc. Even if short-lived, increase in inflation is likely as the revenue neutral rate (RNR) for services is expected to go up. All services (including telecom and financial services) will see their final product taxation going up from the 15% service tax at present.
Globally prices of food items like edible oils and sugar are rising. India imports a major share of the edible oils it consumes. Increase in global prices will have an inflationary impact on domestic prices. Data on global food price index shows an upward tick in momentum of food prices over the last few months.
Global energy prices (oil and coal), too, seem to have bottomed out. Global crude oil prices are up nearly13% from a month ago and about 35% since the beginning of 2016. Domestic retail prices of diesel and petrol, too, have undergone upward revisions—having positive first and second round impact on inflation. With the most recent hike in fuel prices, inflation (y-o-y) in petrol stands around 3.7% while that in diesel stands at 19.1%. Many experts expect global oil glut to balance out towards the end of 2016 and prices to rise in 2017. This will impact headline CPI inflation, as well as inflation expectations.
As per the RBI’s inflation expectations survey (June 2016), households expect inflation to pick up in the next quarter as well as over the next year. Inflation expectations were on a downward trend during the last fiscal, but 86.5% of the respondents expect food prices to rise over the next quarter.
Moreover, 38.3% of the respondents expect food prices to rise more than the current rate over the next quarter, as compared to 30.3% in the previous survey. Also, 72.7% of the respondents expect non-food product prices to rise over the next quarter. With further transmission of easy monetary policy and recent rise in food and global oil prices, inflation expectations might drift upwards.
Demand driven inflation (core ex-TnC) has fallen from 7.5% in FY14 to remain sticky around 5.5% over the last two years. The short term volatility in inflation, however has been driven by supply side factors. With capacity utilisation at low levels, perhaps some amount of demand driven inflation may be good news for the economy.
Further attempts to bring down headline inflation via rate hikes might actually hurt demand and stall economic recovery. Therefore, a better strategy would be to have a target for demand side inflation. Unless this is done, the hide and seek of India’s inflation will continue to bother the Reserve Bank of India.
Agarwal and Priya are corporate economists based in Mumbai.