Columns: Top 10 reasons for inflation decline

Written by Surjit S Bhalla | Updated: Oct 1 2014, 23:29pm hrs
There are at least 10 reasons why it is likely that RBI will be forced to cut repo rates well before the market expects. Most market participants do not believe that RBI will cut rates at all until late-2015. In this article, I present evidence (yet again!) that the Indian economy can absorb (needs) rate cuts without any danger of generating inflation. Hence, either I will be gloriously wrong, or several market experts (including the IMF) will be. RBI, a major actor in this duel, has decided to plead something akin to the Fifth Amendment of the US Constitution (right to remain silent, in order to prevent self-incrimination). In the monetary policy statement released yesterday, RBI concludes: ... future policy stance will be influenced by the Reserve Banks projections of inflation relative to the medium term objective (6% by January 2016), while being contingent on incoming data. In other words, RBI cannot make a mistake because it will cut rates, when it will cut rates!

The top 10 reasons, in increasing order of importance, of why one should expect RBIs 6 % target for January 2016 to be reached:

10) MGNREGA: This rural employment program is inflationary because its operation pushes wages up beyond productivity growth. I have never been a believer in this way-out-of-the-box reasoning for the simple reason that even in the best of times, MGNREGA never provided wages for more than 1% of rural workdays. But believers please note: the R33,000 crore of expenditure budgeted for FY15 is worth half (in real terms) of the R40,000 crore level of expenditure in FY10.

9) Rainfall: Around June 2014, we were talking of a drought situation with its attendant effects on food inflation. Again, precious little evidence exists that droughts have any impact on inflation, or food surplus causes disinflation. The two years, 2012 and 2013, were in the top third of rainfall for India since 1871and they were among the two best years of agricultural productionand the two worst years for food inflation. So much for that idea, Sirji.

8) Expectations: Thankfully, the September monetary policy statement does not mention the phrase inflation expectations even once. If there is a departure from RBI statements for the last six years, it is this. I guess RBI must have concluded that its inflation expectations survey is worse than junk. This is significant progress.

7) World growth: Unlike 6 months ago, the world GDP is on the brink of a recession (measured as 3% growth). Certainly, the US is doing very well, but it may not do so for very long. Growth in the rest of the world, including Europe, Japan, China and India, is not burning any decks with scorching pace. Indeed, these economies are screeching to a relative halt, i.e., decelerating. Add to this the multitude of political problems worldwidenot a recipe for either growth or inflationary pressures.

6) End of quantitative easing in the US (and England): This is another one of the great falsehoods propagated by the inflation bulls. Let me see if I get this rightthe end of the QE will dampen growth, slow down already-low inflation, and this will cause prices to rise in India

5) Persistence: Instead of inflation expectations, we now have a new explanation in townpersistence of inflation. Whether persistence is present or not is an empirical matter, and something that can be derived from past data. What does one mean by persistence Habit, i.e., inflation stays high because I continue to expect it to be so. However, in India, empirical estimates of persistence in CPI inflation converge around 5 quarters i.e., there is hardly any persistence in annual inflation data. Got to look under some other rocks to find persistence of inflation in India.

4) FAO world food prices: Meat prices are at their all-time peak but with Hindutva and vegetarianism rising, this inflation is no threat to India. But indices for dairy, and edible oil (and sugar) are all down more than 40% from their 2011 peak, around the same time when RBI (and the IMF) began screaming protein inflation. And cereal prices are down 32% in the same time-period. I guess we should soon see the food ministry arguing for a minimum of 20% reduction in the minimum support prices (MSP) for wheat and rice, especially since the rise in world food prices was the reason offered by the ministry to raise the MSPs sky-high over the last six years.

3) MSP inflation: The UPA government increased the MSP by only 6.7% in 2013 and 4.2% in March 2014. As I have argued several times in these columns for the last three years, the key driver of inflation in India is food inflation (food accounts for 50% of the CPI) and the key driver of food inflation is the MSP set by the government. Unless the Modi government decides to learn nothing from the past (little chance of that), it is unlikely to raise average MSP by more than a few percentage points in October 2014. Which means that a CPI inflation figure of 5%, or less, is baked for next year.

2) Developing country inflation: Maybe inflation can intrude from outside since India is now integrated with the world economy. But, world growth is down, as is world inflation. The median developing country CPI inflation for the last three years has averaged 3.8%, the fifth-lowest such increase since 1975. Further, world crude oil prices (Brent) are now more than 15% below their peak of 115 just three months ago.

1) Inflation targeting: RBI is comfortable with reaching the inflation target of 8% in December 2014, but less sanguine about reaching the 6% target by January 2016. Because of so many known unknowns over the next year Indeed, Governor Raghuram Rajan stated that there are still significant risks towards achieving the 6% target! In December 2013, yoy CPI inflation in India was 10%, and RBI targets for 2014 and 2015 can be seen as a drop in inflation of 2 percentage points (ppt) per year. For all the reasons stated above, it is likely that December 2014 will see a handle much closer to 7% than 8%. (Oxuss forecast for yoy CPI inflation for September 2014 is 7.2%or less). Thus, if the 8% December 2014 RBI forecast can be bettered by 1 ppt then why not the same for the 6% December 2015 forecast, a year for which the conditions for inflation decline will be even more propitious (For starters, the persistent habit of expecting high inflation will be less!)

Of course, the monetarists and those destined to be wrong can merrily point out that all of the above conditions could reverse and we may be back with high inflation; hence, one can never be too careful. Unfortunately, Black Swan events cannot be predicted with any accuracy. Build no roads and there will be no accidents has been the overriding motto of the Indian bureaucrat. And yes, while we are being risk-averse, we should also remember that pigs may fly in 2015 and thereby, cause inflation to spike.

The author is chairman, Oxus Investments, an emerging market

advisory firm, and a senior advisor to Zyfin, a leading financial information company. Twitter: @surjitbhalla