Improvement in rural wages is not good enough. It is just a return to trend growth after lying below it for a while, and more importantly, trend growth is falling.
It is well acknowledged that CPI inflation has fallen dramatically this year (from 5.1% in January to sub-3% in November), and 70% of this disinflation has been led by the fall in rural inflation. After several years of rural inflation remaining firmly above urban inflation, it has recently fallen below it. The ‘excess’ inflation in rural India vis-a-vis urban India (calculated as rural inflation minus urban inflation) has fallen across all components—food, core and fuel. The main cause for rural inflation falling rapidly is weak rural demand. Growth in rural wages has been slowing (notwithstanding a small rise towards trend, recently).
If consumer sentiment is a proxy, then urban demand is doing better than rural demand. This explains the fall in both excess core and excess food inflation of rural India. The former is an output gap argument. The output gap is likely to be negative in rural India and positive in urban India, thereby pulling down the ‘excess’ core inflation in rural India. When incomes are low, demand for expensive food items (for instance milk and animal proteins) is weak, leading to a fall in their prices. All told, the weakness in rural growth (versus urban), seems to be pulling rural inflation lower (more than urban).
To be fair, things are not that bad. On a sequential (q-o-q, seasonally adjusted) basis, rural incomes have been improving a little. This has been driven primarily by non-agricultural activity (particularly government sponsored construction), which eventually lifted agricultural wages. Alas, as argued above, the improvement in rural wages is not good enough. It is just a return to trend growth after lying below it for a while. And more importantly, trend growth is falling. So far, higher MSP increases have not been able to raise food prices (and thereby wages). If public sector construction slows following the national elections in 2019 (as the government shifts its focus back to fiscal consolidation), rural incomes, and with them food inflation, will remain contained for longer.
This has implications for monetary policy. The combination of the 25% fall in oil prices since the last policy meeting, the 5% appreciation of the ` versus the USD over the same time, and the absence of any MSP-related food inflation, suggests that inflation will remain low for longer. Simply updating the last few months’ inflation numbers and applying our new oil assumption of $65-70 per barrel for the next two years, is lowering our annual inflation forecasts.
Growth has also moderated. The July-September quarter GDP growth has come in weaker than expected (7.1% y-o-y versus market expectation of 7.5%). After predicting two rate hikes in 2019 (in February and June, respectively), only one should follow now. A final rate hike of 25 bps in the June meeting (right after elections), and a prolonged pause thereafter, is forecasted.
Edited excerpts from HSBC’s India RBI Watch (December 3, 2018)
Co-authored by Aayushi Chaudhary and Dhiraj Nim