By Pranjul Bhandari
India, an economy infamous for high and sticky inflation, is currently coming to terms with the opposite phenomenon—inflation over the last year is not just falling, but falling more than expected. Inflation forecast errors have become one-sided. Moreover, inflation components continue to confound, with persistent divergence between food and core prices. In the latest reading, food inflation is at -1.3% and core inflation is at 5.8%, with a mysterious 7 percentage point gap between them. Headline inflation at 2% is well under the 4% target. The big questions doing the rounds are: why hasn’t headline inflation been converging to core over the last year, as the academic papers testing for the post-2013 period suggest? Despite inflation expectations being better anchored since 2013, why is core inflation rising? Will headline inflation eventually increase all the way to 5.8% (where core currently stands)?
Does core converge towards headline or the other way around? After testing this, there is strong evidence of what some other papers have also found— that the prex-2013 period was characterised by core inflation converging to headline, and the post 2013 period being characterised by headline inflation converging to core. A combination of two forces have defined the distinct phases: (1) the nature of food price shocks and (2) the leanings of monetary policy. The pre–2013 period was characterised by rising food inflation and loose monetary policy (as characterised by real rates). Inflation expectations became unanchored. Core inflation was elevated as transitory shocks got generalised more easily. And all of this manifested in core inflation converging rapidly towards headline.
The post–2013 period is characterised by falling food prices and tight monetary policy. A combination of low global commodity prices and good harvests pushed food inflation down. Alongside this, as RBI embarked on inflation targeting, it consciously kept real rates in the positive terrain. As a result, inflation expectations became more firmly anchored. Transitory shocks began to fade away more quickly. All of this is resulting in headline converging towards core. So, if we are in a phase where inflation expectations are better anchored and there is evidence that headline is converging more towards core, why have headline and core inflation been moving in opposite directions over the last twelve months?
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There have been a slew of price shocks that have distorted relative prices (of both food and core) and hindered convergence over the last year. While food inflation had been falling since 2011, the decline picked up pace in early 2018. This was led by both structural and cyclical factors. As demand recovers, the cyclical pressures could reverse. Core inflation is not in equilibrium. It is in flux, grappling with a multitude of shocks, which need careful parsing through.
Expect it to stabilise at lower levels. Once the relative price distortions ease, food inflation will tick up gently and core inflation will fall to a more stable level. It is then that headline inflation will converge towards core. When thinking about inflation convergence, it is important to make note of any shock that may be prevailing during the period. In the face of price shocks, particularly those which may prevail for an extended period, headline inflation may appear not to converge to core.
What is keeping core inflation excessively elevated? How long will the shock last? Core inflation suddenly spurted up in October 2018, led by the health and education components, particularly in rural India. What were the causes? There is econometric evidence that, over time, education inflation converges back to core inflation (and core inflation does not converge to education inflation). This means that shocks to education inflation are more idiosyncratic in nature, and tend to fade away eventually. A similar test for convergence throws up evidence of both health inflation converging to core and core inflation converging to health6. This suggests that health inflation may be susceptible to both short-lived and long- lasting shocks.
This time around, there are media reports suggesting that the spike in health inflation could have been led by any of these: (1) Since September 2018, the agency that collects rural health data has been changed from the postal office to NSSO; (2) ban on certain popular generics in India; (3) a crackdown in polluting factories in China from where a lot of medicine ingredients come, and (4) impact of the new health scheme – Modicare. While it is difficult to ascertain the exact reason of the spurt, it is worth noting that, if it is a one-time jump up in the health index (for instance, led by a change in the way data is collected), it would stay in the inflation data for a year, but dissipate thereafter. Oil at $85/barrel in mid-2018 coupled with a sharply depreciating rupee was a perfect recipe pushing core inflation higher. The fall in oil prices to the $65/b ballpark and some stabilisation in the rupee is likely to ease that pressure with some lag.
Higher GST rates, particularly for the services sector (like luxury hotels and some financial services), could have pushed up the core inflation index. This rise is likely to remain in the core inflation data for about a year, before fading. The selective cuts in GST rates over the last few months is likely to hasten the normalisation in core inflation. Once these shocks fade, core inflation could fall by 100 bps one year from now. (The risk is that some of the shocks turn out to be more long-lasting than those accounted for, keeping core inflation elevated for longer).
Once core inflation is on a stable footing at the 4.5-5% range (depending on the exact definition), and food inflation begins to normalise to the 3.5% levels, led by improving rural incomes and a low base, expect headline inflation to converge gradually towards core, resting at the 4% ballpark one year from now (Jan-Mar 2020). Until then, however, headline inflation could remain under 4%. Expect a 25 bps repo rate cut in the April meeting, taking the policy repo rate to 6%. Even with this, real rates will remain in the positive terrain, anchoring inflation expectations further and strengthening the process by which headline inflation converges to core.
Edited excerpts from HSBC’s India’s Lack of Inflation (February 18)
With inputs from Aayushi Chaudhary and Deep Nagpal, an economist and associate with HSBC respectively
The author is Chief economist, India HSBC Securities and Capital Markets