Much of the talk around RBI’s policy decision in December was centred around US Fed’s move on the global front and inflation data on the domestic front. The event of Fed rate hike now lies behind us, and therefore RBI must keep a close watch on inflation before taking further action.
India’s retail inflation has been on a declining trend since 2014. It fell from a peak on 11.5% in November 2013 to a historic low of 3.7% in July 2014. In fact, CPI inflation halved from 9.4% in FY14 to 4.7% in FY16 (year to date). However, what’s interesting to note is that this decline has not been broad-based. So, what has contributed to this 4.7% drop?
Five categories—cereals, vegetables, housing, fuel & light and transport & communication—accounting for about 40% of the CPI basket have contributed almost 80% to disinflation since FY14. Cereals and vegetables contributed 57% to overall headline disinflation, while housing, fuel & light and transport & communication together accounted for remaining 23%. Rest of the categories, constituting 60% of the CPI basket, accounted for 20% of disinflation.
The fall in food inflation was aided by a fall in global food prices, along with some steps taken by the government.
De-listing fruits and vegetables from the APMC Act, imposing stock limits on onions, pulses, edible oils, etc, under the Essential Commodities Act, and modest increase in MSP compared to previous years played a big role in taming inflation.
For cereals, the decline has been more secular. Vegetables prices have seen seasonal spikes, but broadly have been on a declining trend. Lower MSPs have an indirect impact on vegetable prices due to substitution effect, as higher MSPs incentivise farmers to allocate more resources towards cereals and dis-incentivise vegetable farming, thereby leading to higher prices due to supply shortage.
While the headline inflation number is what we all face, what RBI essentially tries to target via its monetary policy is 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 & light and transport & communication (petrol and diesel have nearly 28% weightage in transport & communication) from headline numbers. This excludes the complete impact of volatile food, fuel and international energy prices from inflation. This category core, excluding transport & communication, has fallen, but not as drastically as other volatile components of CPI. It remained sticky at around 5.5% for the past one year. One possible reason could be that savings on fuel have translated into higher discretionary spending. Thus, demand-driven inflation has remained sticky and the fall in traditional core prices (excluding food and fuel & light) has been mainly due to fall in transport & communication category.
After touching a low of 3.7% in July and August 2015, retail inflation rose to 5.4% in November. This increase has been driven by pulses, edible oil, vegetables prices and a sticky core (excluding transport & communication) inflation. Month-on-month (seasonally-adjusted) core inflation has been rising since July last year. While headline inflation remains within RBI’s comfort level, there is a possibility that it may rise sooner rather than later.
Energy prices are expected to remain at low levels in the near future; however, they may rise from current levels.
Glut in the global crude oil market has pushed down prices significantly. With prices at such lows, oil production has become unviable for many producers, especially in the US shale oil industry. According to the Energy Information Administration (EIA), US oil production is expected to fall by 0.5 million barrels a day in 2016. US rig count has fallen, which will lead to lesser supply. Various estimates suggest that drilling and exploration companies slashed their capex by around $150 billion in 2015 and a further $115 billion cut is expected in 2016. Some OPEC producers too might cut back production. While all these will push up oil prices, increased output by OPEC and Iran will likely put a softening pressure. Even if oil prices remain low—rising only moderately—the deflationary impact of the same will be limited, owing to low base effect.
Apart from the possibility of an upturn in global energy prices, inflation might get a push from the implementations of the Seventh Pay Commission, which has recommended a 23.5% rise in overall salaries and pensions of government employees, effective from January 2016. Basic salaries could be increased by 16% and house-rent allowance by 138.7%. In the past, pay revisions have resulted in sharp rise in inflation. Now while the current hike may not have as much impact on inflation as the Sixth Pay Commission had, due to lower capacity utilisation levels compared to 2008, it may put some upward pressure on an already sticky core inflation, due to increase in discretionary spending. A sharp jump in house-rent allowance will likely push up housing inflation. Inflation in other core categories like household goods & services, pan, tobacco & intoxicants and health has remained sticky.
Moreover, RBI started cutting the repo rate in January 2015 and has so far slashed it by 125 bps. However, banks have slashed their rates by just 60-70 bps. The full impact of monetary policy on inflation and GDP will be seen once it is fully transmitted. In its bid to ensure speedy and effective transmission, RBI recently changed the way banks price loans. Currently, banks follow different methodologies in computing their base rate—on the basis of average cost of funds, marginal cost of funds or blended cost of funds. From April 1, 2016, banks will have to compute interest rates on advances based on marginal cost of funds. One hopes base rates based on marginal cost of funds should be more sensitive to changes in policy rates.
RBI’s inflation expectations survey too shows that households expect inflation to pick up in the next quarter as well as over the year. Although lower than last year, inflation expectations have been on an upward trend from quarter-ending March 2015. With further transmission of monetary policy and rise in food prices, inflation expectations might be rendered un-anchored.
It appears the short-term volatility in inflation and the recent disinflation has been driven more by food and fuel pressures, while demand-driven inflation has remained relatively sticky. Having said that, this very well may be the end of India’s disinflationary cycle and RBI may have less room to cut rates next fiscal.
Authors are corporate economists based in Mumbai. Views are personal