The central bank must conduct an in-depth research study to examine why food prices are not restoring despite significant cost pressures and price support
External and domestic factors have completely overturned India’s inflation scenario since the October review of monetary policy. International oil prices have nosedived, and quite unpredictably by 28%, thwarting a few potential upside risks. With this, the current account deficit now appears manageable and expectedly, the rupee has gained strength. Domestically, the most surprising feature has been the near-dead food inflation, in spite of higher MSPs on offer. Together, these developments pose significant downside risks to RBI’s inflation projections.
This will force the MPC to review its October shift in stance from ‘neutral’ to ‘calibrated tightening’.
There shouldn’t be any embarrassment here! Very few had anticipated oil prices to correct so sharply and the global growth outlook to turn pessimistic in such a short period. To the contrary, the MPC stands vindicated for not raising the policy rate in October despite an overwhelming market consensus. In this fast-changing scenario, any further hike in the policy rate is certainly off the radar. Should the MPC revert to a neutral stance in the forthcoming December 5 review to signal a rate cut ahead or be bold enough to turn accommodative and cut the policy rate by 25 bps?
Why should the MPC take such a sharp turn? The tilt of risks to the upside in October projected inflation to rise above the August 2018 print (3.69%) due to several uncertainties in the outlook: the exact MSP impact upon food prices, vulnerability of oil prices to further upside pressures, volatility in global financial markets, pass-through of the sharp rise in input costs in tandem with rising pricing power, possible fiscal slippages at centre and/or state levels, and the staggered impact of HRA revisions by state governments. With the output gap ‘virtually closed’, this outlook motivated the change in stance to ‘calibrated tightening’ on October 5. Headline inflation was then projected at 4% in Q2FY19 and 3.9-4.5% in H2 (4.8% in Q1FY20); these were marked down from the August 1 forecasts (4.6% in Q2, 4.8% in H2FY19, and 5% in Q1FY20) when the risks were evenly balanced.
But the actual inflation out-turn in Q2FY19 is 15 bps lower (3.85%), October headline inflation feebler at 3.31%, while November’s print is commonly predicted even lower. All except fiscal risks have turned around in the opposite direction! In particular, MSPs have spectacularly failed to pull up food inflation; market prices of key food items prevail at much lower levels. Oil prices have reversed from an average $75 in July-Sept and $80 in October to below $60 this month. Volatility in global financial markets persists but EMEs are back in favour; portfolio capital inflow has resumed into India; and the rupee has shed its depreciating trend. Producer pricing power was unseen in July-September results as firms absorbed higher input costs into lower margins. This leaves just fiscal risks. The reality is that headline inflation will undershoot October’s revised inflation forecasts.
Growth indicators present a mixed picture, not significantly different from the October reading. The Nikkei’s Manufacturing PMI rose to a four-month high in October to 53.1 from 52.2 in September and above expectations (51.9). Industrial growth decelerated sharply in August-September however, averaging 4.6% monthly compared to June-July’s 6.8%, and pulled down sharply by consumer durables; capital goods moderated, while infrastructure/construction emerged the key locomotive. Vehicle sales have slowed markedly. The services’ PMI increased to 52.2 in October from September’s four-month low (50.9), driven by growth in new businesses, employment and increased backlog of works. Export growth returned to double-digit in October; imports accelerated too. Second quarter corporate results were overshadowed by a weak base, strong performance of few large firms and producers’ inability to pass on higher costs to selling prices.
RBI will thus redo its inflation forecasts incorporating these developments in its December 5 review. This will be the despite firmness of core inflation, which climbed to 6.2% from September’s 5.82%; minus transport & communication, it was 5.9% and lower when excluding housing (5.66%). Falling oil price pressures, a lack of pricing power and extraordinary persistence of food inflation at weak levels preclude further impulses to core inflation ahead. In fact, the critical issue the MPC faces is how to reconcile the near-closed output gap and reduced slack in capacities with the absence of pricing power? Why are firms unable to pass on higher costs to consumer prices? This matter is essential for the MPC to settle at the aggregate level to remove fear of further rise in core inflation.
Lowered inflation projections will also most likely be accompanied by a return of stance to ‘neutral’, in preparation for a rate cut ahead if the benign price trends persist. Risks from global growth as well as the trajectory of oil prices and food inflation are tilted downwards at this point. Especially from food inflation, the key surprise variable causing frequent overestimation of headline inflation projections. Minus the inexplicable and continuous drag down from food inflation, it is unlikely the sudden downturn in global economic outlook and oil prices may have wreaked so much havoc in inflation forecasts.
This also raises an important question RBI can no longer avoid and must squarely confront: what underpins the collapse in food prices? Their inability to hold up no matter what is startling. One has to only set July’s high MSPs and increasing costs of farm inputs (high speed diesel, fodder, seeds, fertilisers, pesticides and machinery) that reached 7.4% y-o-y in August (as per RBI’s last inflation report) against food inflation’s long continuing weakness that is turning into a virtual death. This extraordinary concurrence demands better understanding and explanation, if only to tune policy responses.
A sharp decline in consumer food price inflation that occurred post-demonetisation bottomed out in June 2017; weak base effects lifted this to its 4.96% peak in December 2017. Since then, food inflation has steadily decelerated despite the significantly weak base. RBI ascribed the initial food deflation to seasonal oversupplies accentuated by firesales of perishables due to demonetisation. Subsequently, it has noted the downside surprises that have serially dragged down its inflation projections but said little else on the subject. More than a year ago, it was debated if the food inflation decline was structural or cyclical. If indeed structural, do we understand that food demand-supply price equilibrium will remain significantly below 2% across cycles? Average food inflation since demonetisation has been 1.66%.
RBI needs to say and tell us more on these trends. It is urgent that the central bank conduct in-depth research to examine why food prices are not restoring despite significant cost pressures and price support. Is it linked to permanent demand destruction caused by demonetisation which resulted in closures of numerous small businesses and job losses? Are GDP statistics falsely portraying a healthy growth picture, especially of the informal sector, which sits uneasily with the absence of demand-side price pressures? Above all, RBI’s inflation edifice is built upon transmission of food prices to wages and generalised prices thereon. Take away food inflation from this structure and the inflation model requires redoing. We look forward to some explanations and answers from the central bank on this.
-The author is a New Delhi based economist