We have said this before, and have found new evidence since. Inflation in India has fallen dramatically, and while the excessively low levels of FY18 may not be sustainable as some of the drivers are short-lived, we think the rise back up may not be too sharp either.
We have said this before, and have found new evidence since. Inflation in India has fallen dramatically, and while the excessively low levels of FY18 may not be sustainable as some of the drivers are short-lived, we think the rise back up may not be too sharp either. Stripping out the temporary noise around inflation, we endeavour to tease out the likely underlying momentum for the next three to five years. We find a common conclusion across the different methodologies we employ: Barring unforeseen exogenous shocks, India may have already become a 4%-inflation economy. Consider these: India’s inflation differential with the world is normalising. Various behavioural economics experiments have shown that people tend to pay attention to those events that have transpired more recently. This is also known as the salience effect. We believe that some of the inflation commentary in India is influenced by this effect. Let us explain. The long-term differential between global inflation and India’s inflation has been around 2ppt. However, this differential soared to over 5ppt during 2008-13 when inflation in India shot up to 10%.
The salience effect of the high differential episode is so fresh in people’s minds that they started to consider that as the normal. In fact, it was the opposite, i.e., it was an abnormal episode in India’s inflation history. Since then, the factors that caused inflation to soar so rapidly have reversed; Minimum Support Prices (MSPs) of agricultural produce have been kept range-bound, the INR has been much more stable, and global commodity prices are subdued. If India has indeed gone back to the pre-2008 differential, our forecasts for global inflation over the next few years suggest that India’s inflation should automatically trend below 4.5%.
Inflation expectations have fallen into a virtuous cycle
In a recent note, we ran a series of theoretically rigorous regressions to establish what really drives inflation (goo.gl/GaKMNy). We found that inflation expectations, both backward and forward combined, explain about 75% of the trends in actual inflation. On further investigation, we found that inflation expectations are a stubborn animal. Once they take hold, they feed off themselves, falling into a multi-year cycle. The period 2008-13 was a vicious cycle of inflation expectations in which higher inflation in the past triggered higher inflation in the future. However, the period since 2014 to now is a virtuous cycle in which falling inflation each year is triggering even lower inflation over the next.
This virtuous cycle could be long-lasting, given that it is associated with structural changes such as the onset of inflation targeting and subdued MSP increases. Looking across 17 emerging economies, we found that inflation targeting tends to lower inflation rates. In two-thirds of the EMs, inflation targeting lowered inflation rates to the target range by the fourth year of its initiation. The fourth year, in India’s case, happens to be 2017.
Plugging forecasts for the various drivers of inflation into our model, we found that inflation expectations seem to have fallen to a level that has already anchored India’s inflation rate at the 4% target.
The resting point for food prices could be low
Over the last two months, food inflation has been clocking -0.7% y-o-y, the lowest level since the turn of the millennium. We have written recently that the significant fall in food prices has been led by a confluence of reasons (goo.gl/EoYn9R). Some are short-lived (e.g. destocking impact of demonetisation and GST), some one-time (e.g. a bumper crop in 2016 after a two-year drought) and some structural and long-lasting (e.g. more efficient open market operations in releasing food grains from state granaries, allowing farmers to bypass state machinery and sell fresh produce directly in the market, focus on importing shortfall items such as pulses and edible oils and clamping down on the network of hoarders). But the question we get asked all the time is: where will food inflation rest once the short-lived forces fade? We try to answer this systematically through the following steps:
In a previous note, we found that food prices over the last 12 years were well explained by three variables—reservoir levels, MSPs and international food prices. Assuming normal reservoir levels, MSP increases at manageable levels and only gradually rising international food prices, our model suggests that food inflation could be around 7% over the next few years.
However, this number originates from our long-term model, which does not account for the long-lasting disinflationary impact of recent structural reforms in food supply management (since 2014). We set out to quantify that separately. Food inflation fell by ~5 ppt between 2013 and 2015. The variables that became supportive of lower food prices specifically during that period were (1) falling global food prices and (2) structural reforms in food supply management. Our model shows that falling global food prices shaved off 2 ppt from food inflation. This means that all else being equal, supply-side management shaved off the balance of 3 ppt from food inflation. Once we are able to get the impact of better supply-side management, we can safely subtract it from our food inflation forecast of 7% . We assume here that there have been no new and significant food supply-side reforms since 2015. This exercise suggests that as the one-off factors affecting food inflation fade but structural factors remain, we expect food inflation to settle at 4%. What does this mean for overall inflation? With food inflation at 4%, core inflation hovering around the same level (as is the case now) and oil prices under $65 per bbl, headline inflation is likely to rest at around 4%. Looking at a multi-year forecast for inflation through three different lenses throws up a similar result. India is perhaps already a 4% inflation economy.
The possibility range for rate cuts
Having discussed why we believe India is already a 4% inflation economy over the foreseeable future, we move on to discussing prospects for rate cuts. If RBI was a purist inflation targeter, there would be no space for rate cuts (or hikes) given our belief that it is already at the 4% target. As such zero rate cuts would be the lower end of the possibility range.
However, the RBI has often spoken about real rates. Let’s for a moment assume that the RBI is a real rates targeter rather than an inflation targeter and has a preference for keeping real rates at the 1.5% handle, which is where it rested for much of 2015 and 2016. Marrying our longer term underlying inflation forecast of 4% with real rates of 1.5% suggests the repo rate could be cut by 75 bps. This, then, could become the upper end of the possibility range.
The truth is that the RBI is an inflation targeter, and not a real rate targeter, and has a natural preference to be at the lower end of the possibility range. Also, it is cognizant of the risks associated with monetary accommodation during periods of financial impairment. In the June MPC minutes, Deputy Governor Viral Acharya categorically said that: “tolerance for a slightly higher real rate of interest is justified to ensure weak banks do not find relatively low the hurdle rate for ever-greening (perennial extension) of bad loans. What is required for monetary policy to do its job better is to address the stress on bank (and highly-indebted borrower) balance sheets”.
All considered, we continue to expect a 2 5bp rate cut in the August 2 meeting. We expect the central bank to maintain its neutral stance, which we believe is consistent with moderate rate cuts. Beyond August, we see a risk of a further 25 bp rate cut later in the year if CPI inflation (without the direct impact of the seventh pay commission housing) continues to undershoot the 4% target, even in the second half of FY18. For now, however, we see it rising to the 4% handle over 2H, but much will depend on reservoir levels and price of perishable food items from here on.
Chief India Economist, HSBC Securities and Capital Markets (India) Private Limited.
Co-authored with Aayushi Chaudhary (economist), and Dhiraj Nim (economics associate), HSBC Securities and Capital Markets (India) Private Limited.