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INDIA INFLATION – Digging deeper
After improving for several months, the headline
WPI jumped to 8.4%YoY in December, led by
sharply higher prices of vegetables (especially
onions). While a 25bps hike by the RBI next week is
a done deal, we analyze the multiple drivers that offer
a more complete picture of the inflation challenge.
At the very outset, it is important to appreciate that by
focusing on wholesale price index (WPI) rather than
a proper consumer price index (CPI), the RBI makes
its own job more difficult. This is because the WPI is
inherently more sensitive than CPI to changes in
input prices. Higher commodity prices, for example,
have a faster and a more complete pass-through to
WPI than to CPI inflation. All other countries target
CPI inflation, which is generally lower than the WPI
or PPI (producer price index) inflation.
There are six key drivers of inflation, in our view: (1)
cyclical pressures as growth has been stronger than
trend; (2) higher global commodity prices, especially
for crude oil; (3) boost to aggregate demand via the
government’s active initiatives to empower rural
India via employment-generative social safety net
programmes; (4) slow pace of fiscal consolidation; (5)
rising affluence that has increased demand for
protein-rich food, which in turn has worsened the
supply-demand imbalance owing to a lack of
adequate supply response; and (6) temporary
weather-related food price shocks.
The above drivers can be grouped as: supply- Vs
demand-driven; domestic Vs external, cyclical Vs
structural, food Vs nonfood, and temporary Vs
permanent. Ironically, the government’s initiatives
that have actually contributed to the resilience of
rural India’s consumption are also the ones that have
partly contributed to the inflationary pressures, as
supply of certain food items has not increased
meaningfully. Still, monetary actions and fiscal
initiatives cannot work against each other, and the
long-term response has to be on the supply side.
The trend of WPI inflation had been improving in
recent months. Headline WPI inflation had eased to
an 11-month low of 7.5%YoY in November, before a
temporary weather-related hit to vegetables pushed
up inflation in December to 8.5%. Nonfood
manufactured goods inflation was a touch softer in
December at 5.3%YoY, but this is likely to rise owing
to rising global commodity prices. After declining for
ten straight months, the food composite subindex
(weighted average of food components of the
primary articles and manufactured goods subindices)
jumped to 8.6%YoY in December compared to a
three-year low of 6.1% in November.
Within food, the prices of staple items such as wheat,
rice and pulses (an important source of protein) are
not showing distress, despite the adverse global price
pattern in these items. The December spike in food
inflation appears to be concentrated in fruits and
vegetables (+22.8%YoY), which in turn has been led
by a whopping 45.8% spike in the price of onions.
By their very nature, temporary food shocks are
treated differently, as these are typically short-lived
and last less than the typical lag between monetary
policy action and its effect. However, a lasting food
shock becomes a different animal as it then begins to
affect expectations, which in turn can have a more
permanent affect on either the headline inflation rate
or some version of core inflation. Thus, central banks
cannot directly affect food supply with interest rates,
but monetary action cannot be avoided when a food
shock threatens to have a more permanent effect.
So far, the bulk of the heavy lifting on policy
normalisation has been done by the RBI, which
increased policy rates by an effective 300bp in 2010.
The upcoming federal budget offers a good
opportunity to step up fiscal consolidation, which in
turn should soften aggregate demand. The challenge
for monetary policy becomes greater when there are
also numerous supply-side drivers that complement
demand-driven factors that a central bank can directly
affect with tighter policy.
The correct response to the supply-demand
imbalance for protein-rich food is higher supply, not
aggressive monetary tightening that will surely derail
growth at a time when the much-needed investment
upturn is still in its infancy, and could be at risk. The
cyclical demand-driven pressures should ease, as
growth is already rolling over, even if one discounts
that the volatile industrial production data that
probably exaggerates the deceleration. Further
progress on fiscal consolidation should also soften
domestic demand.
However, the threat from higher global commodity
prices still persists, and is one of the reasons why the
pass-through into local prices will prompt the RBI to
tighten further, starting with a 25bpp hike and a
hawkish guidance on 25 January. The RBI has to
raise policy rates further this year, but it is important
to realise that India's inflation challenge is not due to
excessive monetary expansion, as M3 growth is
running close to the RBI’s guidance of 17%, and
there is already far greater tightness in local liquidity
conditions than what the RBI intends.
Since all the inflationary pressures are not from the
demand side that the RBI can directly address, a
super-aggressive tightening will surely derail growth,
thereby creating a worse combination of still-high
inflation owing to higher commodity prices, lower
growth and worsening of the fiscal dynamics.
Growth is already softening, and hence the RBI will
have to be more cautious in its tightening, especially
since the full effect of its 300bps normalisation in
2010 has not been fully transmitted. Still, headline
inflation will be higher for longer owing to rising
global commodity prices. Indeed, after a temporary
improvement following the December spike, WPI
inflation is poised to climb to at least 8%.
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