Reserve Bank’s effort to tame CPI inflation has just become a little harder. With inflationary expectations reversing as per its latest survey round, the genie that the central bank hoped to bottle is once again out loose. Policy-makers and analysts who believe there will be room for a further cut in the policy rate and that Governor Raghuram Rajan may soon oblige if the monsoon turns out to be near-normal in the next two months are failing to appreciate that the reversal in inflationary expectations has raised uncertainty. This makes it difficult for RBI to significantly alter its current CPI-inflation forecast of 5.8-6.1% in January 2016.
At a real rate of 125 bps, RBI had already gone below its stated position of sustaining a real rate in the 200-150 bps region. Perhaps the central bank was emboldened by a decline in households’ inflationary expectations to single digits earlier. However, their reversal has put a spanner in the wheel—an unwelcome development that could be linked to a reversal in CPI-core inflation itself. Untamed inflationary expectations, adaptive or otherwise, could compel the central bank to crawl back as its inflation target becomes steeper going forward. This would become necessary as RBI calibrates its policy response to condition expectations.
The development is even more bewildering as all significant drivers of CPI-inflation remain disciplined: Minimum support prices (MSP) for key food items are contained; the effective expenditure on welfare programme MGNREGA is reduced; the pace of rural wage rate increase is far slower while real estate activity in urban areas, on which urban wages are set, is much depressed. In other words, the links between wages and inflation expectations stand broken.
While it isn’t unusual for food price inflation to shoot up in an uncertain monsoon season due to supply concerns, a dormant feedback channel should normally have ensured that prices of CPI-core items remain immune to such volatility. Even if the common man’s inflation expectations continue to be shaped by spikes in prices of a few food items like potatoes and onions, it is hard to understand why these should get generalised into higher prices for items in CPI-core, and that too in such a short span of time!
This prompts us to look at the other, or the demand-and-supply side of the story. It is triggered by the following question: Why would CPI-core inflation reverse in an economy facing demand compression across sectors, as evident from persistently negative WPI inflation, including its core component? When both goods and services’ exports are languishing, private investment is virtually on a crawl and rural consumption demand deeply dented, can consumption revival in a few urban pockets sufficiently account for resurgence in CPI-core inflation and household expectations?
Can supply be a constraint if there is a negative output gap? At the most basic level, the surplus manufacturing capacities corroborated by very low factory-gate prices, do not quite satisfy this presumption, especially for items that figure in the CPI-core component. Why are then retail prices rising, even as farm and factory prices remain subdued or even negative? Is market distortion allowing traders to dictate margins even in otherwise depressed demand conditions?
This is the context that inspires examination of trade margins, which have displayed an unusual surge amidst considerable demand suppression observed across sectors. Indirect evidence on margin behaviour is provided by the acceleration of gross value added (GVA) in trade (as shown in accompanying chart). The question here is why should GVA accelerate at such a rapid pace in an economy that is simultaneously experiencing a slowdown or even contraction in volumes?
The chart on GVA for trade segment alone (this is part of a larger category that includes hotels, transport, communication, etc) shows it grew 11.1% in FY13 and accelerated to 14.3% in FY14 as per the new national accounts series. Comparable data, i.e.,, exclusively for the trade segment, is not yet published by the CSO for FY15. But quarterly data for the whole category, including hotel, trade, transport and communication, etc, is shown in the chart for last year; the indication is that GVA acceleration in trade would have sustained as growth in this sub-category has traditionally been relatively higher.
In contrast, most indicators suggest a significant slowdown in the volumes traded. For example, exports-imports have either decelerated or even fell; marketable surplus in agriculture was reduced by the poor monsoon in FY14; production of consumer goods has been in prolonged contraction mode; corporate sales growth rarely reached double-digits in last several quarters, and so on. In fact, the GVA-output ratio in the national accounts steadily rose from 67 in FY12 to 67.7 in FY13 and further on to 68.4 in FY14, betraying the extent of profit margins.
The relevant question, therefore, is how have wholesale and retail traders managed to raise their margin, as reflected in the sectors’ gross value addition? While there is a view that lower input costs and efficiency gains explain the higher GVA in the manufacturing sector, there aren’t enough anecdotal evidences to support a similar line of argument in favour of trade. The most plausible case that one can make out is that inefficient and distorted market structures have allowed traders to command ever-higher margins, which defy the logic presented by a slowdown in volume of trade. It is only when markets and institutional structures are so incomplete and warped that such large gaps can persist and prevent efficient price adjustments. When markets, such as they are, allow traders to reap high margins amidst visible slowdown in volumes, the resurgence of CPI-core inflation is more likely an outcome of market structures than demand pressures.
Anomalies like these open up the prospect of increasing efficiency through injecting competition, new and/or better technologies and processes via larger investments in back-to-front infrastructures. Opening up foreign direct investment in the retail segment is an obvious solution to shake up the trade segment, eliminate these fat margins and obtain better, quicker transmission into lower retail prices. It is only when prices are determined in competitive markets that the expectational links between wage and prices can be correctly interpreted as gauge of demand conditions and thereon to decide the course of monetary policy actions. Else, the prices of potatoes and onions that influence households’ inflation expectations, will continue to determine how much steel and power must be produced in the economy!
The author is a New Delhi-based macroeconomist