Watching India’s inflation trends these days gets us humming The Doors’ 1967 popular single, ‘Break on through to the other side’. And why not? Inflation in India has clearly changed sides. From averaging 11% in the FY09-11 period, it has fallen to 4.5% in FY17.
Inflation expectations are a stubborn animal. Once they take hold, they feed off themselves, falling into a multi-year cycle. At present, they have fallen into a virtuous cycle and are likely to stay there, anchoring India’s inflation rate at the 4% target, unless some of the ‘other factors’ turn sour enough to yank them out.
There are two distinctly differing phases in the recent inflation trajectory:
The rise (FY09-11): CPI inflation averaged ~11% during this period.
The fall (FY14-17): And then, all of a sudden, inflation began to fall, from 9.9% in FY13 to 4.5% in FY17. Expectations played the key role, explaining 80% of the fall.
In both cases, the persistence of the cycle was only strengthened by some institutional characteristics unique to India. The setting of rural wages and MSPs leans heavily on inflation in the previous year.
The all-important inflation expectations cycles are initially triggered by ‘other factors’, often the simultaneous occurrence of several of them. In the FY09-11 episode, policy discretion supporting higher MSPs and a large and positive output gap jointly jolted the system, driving up inflation expectations. In the FY14-17 episode, policy discretion supporting lower MSPs, the discipline associated with inflation targeting, lower commodity prices and slower depreciation of the rupee led to falling inflation expectations.
We are in a good space. Inflation expectations, both backward and forward, have declined. Inflation each quarter is coming out to be lower than the previous quarter. The one-year forward inflation forecasts have fallen meaningfully since 2014. Underlying inflation (stripping off food, fuel, petrol and diesel) is already in the 4% ballpark. In fact, if ‘other factors’ remain well behaved, this virtuous cycle can carry on for the next several years, keeping headline inflation in the 4% ballpark.
Can ‘other factors’ turn sour and yank India out of the virtuous inflation expectations cycle it is currently in?
Growth rebounds: If growth rebounds, the negative output gap can close, imparting upward pressure on inflation. Having said that, our growth estimates after the demonetisation suggest that the output gap will now take even longer to close. We have a long held below-consensus view that GDP growth will likely remain unchanged over the next year. Investment remains weak, urban wages are growing at multi-year lows, government spending may not remain as high, given the fiscal consolidation path, and the rise in exports over the last few months is finally showing some signs of moderation. True, rural growth could come in high if rains are strong, but that would just about offset the weakness from other sectors. Given this outlook, we estimate that the output gap will only close by end 2018.
Oil prices rise and the rupee depreciates: The rupee has appreciated 5% since the start of 2017. By our estimate, this should lower inflation by 30bps. Furthermore, as per the CRB index, international commodity prices across food items, oils and industrial raw products remain contained. Any rise in them could get offset, to some extent, by a stronger rupee.
Rains fail to fill India’s reservoirs: The advantage of using reservoir data is that not only does it capture contemporaneous rains but also accounts for carry-over stock from previous rain episodes, especially non-seasonal rains. This helps explain irregular years, such as 2015, when monsoon rains were deficient, reservoir levels were in surplus, and food inflation remained contained. In particular, we find that the reservoir level in July is most significant. Not surprising, because it captures the moisture in the soil during the sowing months.
So far reservoir levels are looking good (104% of normal as on May 25). However, early rains will be necessary to keep them above normal through the sowing season. The good news is that the onset of rains has been timely so far and the weather bureau expects it to be in the normal to above-normal range.
Housing allowance stokes inflation: The housing allowance of the Seventh Pay Commission could directly add (60-120bp, depending on whether the states implement it in the same year) to headline inflation. However, as communicated by RBI, much of this will be overlooked as a statistical artefact.
What RBI really worries about are the second-round effects of the housing allowance. However, by our analysis, as long as the output gap is negative, it should not be a source of worry. Recall, when the pay and pension part of the pay commission was being implemented in 2016, there were concerns about the inflation impact. Turns out that both the headline and core inflation actually fell over that period. All told, though there are always several risks on the horizon, not all of them may materialise.
On the other hand, some ‘other factors’ could go right:
GST and implementation: While a lot has been said and feared about the GST, it seems that the tax rates have been set such that, if over time tax cuts are passed on to final consumers, and the input tax credit mechanism works smoothly, the GST could actually cause inflation to fall by 10-50bps.
Food reforms: Food inflation has been benign for the last few years. As written before, a part of it could be on the back of structural reforms. States, such as Maharashtra, have liberalised trade in fresh foods in July 2016. Karnataka has emerged as a leader in digital food markets. These states have seen a sharp fall in food prices recently, all of which may not reverse in a hurry.
What should RBI do? There is a general perception that RBI may have moved its stance from ‘accommodative’ to ‘neutral’ too prematurely. Many also believe that the central bank has sounded more hawkish and worried about inflation over the last few meetings than was necessary. However it may have had some ‘special reasons’ for that:
Credibility issues for early inflation targeters: There is enough global evidence on the role of reputation and acting tough in the early days of inflation targeting to influence subsequent expectations.
Financial sector impairment: RBI may be worried that at a time of stress in the banking sector, monetary accommodation and subsequent trading gains hide weaknesses in the loan books, thereby diluting the urgency around banking reforms.
Having said that, a case can be made that for credibility sake RBI needs to rework its inflation forecasts, especially given that actual inflation has sharply undershot the forecasts (for instance, back in February, RBI was expecting March inflation to come in just below 5%; turns out it came in at 3.9%).
We expect RBI to lower its inflation forecast for FY18 at the upcoming June 7 meeting. It currently stands at an average 4.5% for 1H and 5% for 2H. Our own base case forecasts are more sanguine, 3.1% and 4.2%, respectively, for 1H and 2HFY18.
Given the ‘special reasons’ at play, we continue to hold on to our view that the RBI will keep the repo rate unchanged at 6.25% over the foreseeable future.
However, if: (1) ‘other factors’ turn even more benign, for instance, early rains push up reservoir levels significantly above normal, or (2) if RBI, through its commentary on June 7 and minutes on June 21 indicates that the wave of lower inflation expectations indeed is likely to continue having an overpowering effect, there are risks of a 25bps rate cut at the August meeting.
By then, it is also likely that RBI would have seen two CPI inflation prints trending well below 3%.
Excerpts from HSBC report “India RBI Watch” (June 2)