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There is a general sense of euphoria on consumer price inflation (CPI-Combined) coming in at a new low of 2.99 per cent for April 2017, down from the March 2017 number of 3.89 per cent, mainly on account of lower food inflation and the base effect. The observed values present a downward trajectory and show inflation to be benign. However, beneath the surface, the inflation outlook has many pressure points in the near term, notably the continued elevated inflation expectations, the non-generalised nature of headline inflation and the persistence of inflation excluding food and fuel.
The inflation numbers came with a base revision and enhanced coverage, both of which are welcome. But the common thread running through both the CPI and Wholesale Price Index measures is that headline inflation excluding food and fuel has been sticky. All of these point to symptoms that can present challenges in keeping inflation within the upper band of six per cent under the Flexible Inflation Targeting framework, which targets the CPI-Combined to be at an average of four per cent (plus or minus two percentage points).
The challenges can be seen from the adaptive inflation expectations of households in the RBI’s survey of March 2017, which remained at an elevated level. Inflation expectations looking ahead to the three month period and the one year period were 7.5 per cent and 8.8 per cent respectively. The inflation expectations came in at a level higher than the observed inflation rate for 2016-17 and also the baseline forecast rate of the RBI for 2017-18, i.e. an average 4.5 per cent in the first half and 5 per cent in the second half. More than that, as the last monetary policy report of the RBI observed, the “proportion of respondents expecting the general price level to increase by more than the current rate also edged higher”.
The common thread running through both the CPI and Wholesale Price Index measures is that headline inflation excluding food and fuel has been sticky. All of these point to symptoms that can present challenges in keeping inflation within the upper band of six per cent under the Flexible Inflation Targeting framework
This comes along with a high level of uncertainty in crude oil prices, upside pressure from the implementation of the house rent allowances under the 7th Central Pay Commission (CPC) and an emerging (albeit one off) challenge from the introduction of GST in 2017-18. As the country evidence suggests, the introduction of value added tax has the potential of some upside risks to the inflation. In a report released just the day the April 2017 inflation number was released last Friday, the RBI notes that there are “short-term costs in terms of the pass-through of GST to inflation (though it also points out in brackets that nearly 50 per cent of the CPI is outside the ambit of GST).
The RBI’s April 2017 monetary policy report has detailed the magnitude of upside risks. It says if crude rises to US $60 per barrel, the inflation rate would be higher by 30 basis points compared to the baseline scenario. Second, there is pressure on headline inflation from higher domestic demand coupled with imported inflation from higher global commodity prices. The RBI Report assumes a 10 basis points increase in inflation with a global growth increase of 50 basis points and the resulting domestic growth increase of 25 basis points. Third, the housing inflation emanating from the implementation of 7th CPC house rent allowances both by the Centre and States could result in a rise of 100-150 basis points in the headline inflation. Fourth, the risks of possible El Nino effects taking a toll on the monsoon still remain, and if this leads to the downward growth of agricultural output and allied activities by one percentage point, the impact on headline inflation would be 30 basis points above the baseline. There could be some downside risks too from these sources if the assumptions do not validate themselves. But there is a strong possibility that the balance of risks has a higher weight for upside rather than the downside.
It is pertinent to note that as per the empirical finding of the Central Statistical Organisation (taking into account 140 products and 66 industries), a one per cent increase in crude oil, metals and coal price could result in an increase in headline CPI inflation by 6 bps, 7 bps and 2 bps, respectively.
Moreover, the deceleration in headline inflation rate is not generalised. Mostly, the deceleration is food centric, caused by the demonetisation effect of distressed sale of perishable goods by farmers coupled with lower demand due to wage shocks. The RBI has described it as an “abrupt compression in food inflation”. Non-food inflation has remained sticky and would continue to be stubborn, showing downward inflexibility. This is because cost push pressures are emerging due to escalated manufacturing input costs. It is pertinent to note that as per the empirical finding of the Central Statistical Organisation (taking into account 140 products and 66 industries), a one per cent increase in crude oil, metals and coal price could result in an increase in headline CPI inflation by 6 bps, 7 bps and 2 bps, respectively.
According to the RBI’s industrial outlook survey, most of the firms expect to pass on the higher input costs to the selling price. Concomitantly, the output price inflation will be higher. Thus, even though the headline inflation is on a disinflationary path, the inflation excluding food and fuel (core inflation) remains inexorable. In this light, the RBI needs to re-anchor inflation expectations.
There is merit in the observations of the monetary policy committee member and RBI Executive Director Dr. M D, Patra, (who incidentally is the only career central banker among the committee members) favouring a preemptive strike of 25 basis points increase in policy rate. This may not happen but going the other side to lower the rates, too, would not be warranted at this time.
(R K Pattnaik is Professor, SPJIMR. Jagdish Rattanani is Editor, SPJIMR)