Sticky core could signal potential upside risks
The fall in headline CPI inflation to below-5% in March and an above-normal monsoon forecast have generated expectations for further policy rate cuts in 2016. These are based on the premise that a good rainfall would moderate food inflation, pull headline CPI inflation further down and thus lead to an undershooting of RBI’s 5%-inflation target by March 2017. But a careful analysis of the underlying trends, especially of CPI core inflation that is stuck at a little above-5% for several months, suggests it may be risky for the central bank to lower policy rates any further.
Consider the trends in CPI core inflation. The accompanying graph plots a monthly time series for “CPI core” inflation that excludes the component “transport and communication” and which some analysts call “core-core”. The two lines, respectively, use the old CPI series (base 2010=100) and the new one (base 2012=100). Also plotted is an adjusted old series that incorporates the methodological changes in the new series, which uses geometric mean (GM) instead of arithmetic mean (AM) used in the old series. The CSO’s report had said that using AM in the old series had overstated headline inflation by an average of 60 basis points.
The time series plot marks three distinct phases: in the first, CPI-core inflation remained sticky at an average 7.7% for many months upto early 2014. In the second phase, this declined sharply by 250 bps in a very short span of around six months. And in the third phase, it is again persisting at an average rate of 5.2%. What explains such trends?
The observed core inflation, which is mostly services activities, certainly remains a puzzle. In the initial phase, this was largely attributed by RBI to significant second-round effects arising from elevated, persistent food price inflation in the preceding, several years. The transmission channel, RBI said, was of higher inflationary expectations feeding into accelerating wages that then pushed up non-food, core inflation towards higher headline inflation.
But the central bank never explained why such inflation remained sticky, close to 8% for several months. It did respond with monetary tightening however, raising the policy rate several notches higher to 8%—almost on par with the level of CPI core inflation—in an effort to gradually disinflate the economy. Then came along the elements of “good luck”—international oil, commodity and food prices all collapsed, resulting in lower second-round effects and hence, a sharp moderation in core inflation.
The central bank was quick to claim credit, although one is not certain how much of the decline owed to tighter monetary policy. For one, the services sector continued to grow robustly, exhibiting no sign of demand compression in that period. Two, RBI acknowledged more than once the absence of monetary policy transmission to the lending rates of banks. And three, RBI itself had not anticipated such a sharp correction in core inflation in such a short time-span, of just six months. On closer scrutiny, it appears that core inflation exhibited a “shock response” in a short time-span to multiple, unanticipated developments; in particular to the sharp decline in international oil and food prices, and ironically, a near collapse in rural real wage rates owing to droughts.
This analogy is further buttressed by the re-emergence of stickiness in core inflation, albeit at a lower rate—little above 5%. Why should core inflation persist at this level when food-fuel prices continued to soften further in the last several months? Core inflation seems to be exhibiting downward rigidities, settling into a state of inertia.
How should RBI respond to an emerging situation in which headline inflation could remain persistently lower than core inflation ahead? Should it altogether ignore core inflation and focus on headline inflation, the nominal policy anchor? While unfolding the ‘glide-path’ for the new flexible inflation targeting framework, RBI could not have anticipated such a scenario, but ignoring it could come with its associated risks.
RBI would certainly reappraise its policy stance if a good monsoon indeed results in significantly lower food prices. But it is the alternative scenario that should engage RBI: How should core inflation respond if international oil and food prices witness a moderate reversal; a good monsoon triggers a recovery in the real rural wage rate; and domestic demand gains more strength?
The stickiness in core inflation can only reflect the downward rigidity, a lower bound; while any rise in the wage bill and other costs would be passed on as the services’ sector appears to be less demand constrained. Oil prices are already inching up; The Economist’s index shows a gradual uptick in food prices in recent months; and domestic firms’ balance sheets indicate that wage costs are mounting.
RBI would certainly hope that core inflation declines if food inflation weakens further, thereby creating space for more cuts in the policy rate. But services’ inflation seems to be the “new monster in town” whose behaviour remains unexplained. The visible downward stickiness in core inflation could surprise many by a tendency to move up without much hesitation if the situation gangs up!
The author is a Delhi-based economist