NEW DELHI: Reserve Bank of India (RBI) Governor Shaktikanta Das has been overlooking suggestions that the country will likely see a burst of inflation later this year. However, he may be forced to rethink soon, say economists.
The signs of looming price instability, aka inflation, are all around us. It is crucial for the central bank to keep the inflation below 6%, but the pass-through of a decade-high wholesale price inflation has led to a steady increase in retail inflation. In May, retail inflation, measured by the Consumer Price Index (CPI), surged to 6.3% and economists say there is a strong likelihood that retail inflation in the coming months will rise further, with core inflation likely to remain elevated above 6% levels in June.
Higher recovery in emerging markets has bumped up global demand and has kept international commodity prices at higher levels. Not only in petroleum products, but there has also been a broad-based surge in the prices of metals (particularly steel), cotton, edible oil and chemicals. The rally in crude prices since end-2020 has added to cost pressures, with Brent crude hitting $72 a barrel in June from $33 in March 2020. Adding lockdown-led supply curbs to the mix, we have a perfect recipe of an uncomfortable inflation.
“Increase in commodity prices is having a direct effect across key subcomponents of the CPI. The increase in food prices over the past two-to-three quarters were driven by non-perishables, mainly pulses and vegetable oils, both of which are heavily influenced by global prices. Similarly, among the components of core CPI, clothing, footwear and industrial products have been showing evidence of rising imported price pressures,” says Rahul Bajoria, chief economist at Barclays India.
As crude prices rose, India’s s retail fuel prices also increased crossing Rs. 100 per litre in a number of cities in the past month. For diesel, too, the increase has been sharp from Rs 62.9 per litre in March to Rs 87.3 a litre in June. On scanning the CPI by category, it is clear that transport prices have made the largest contribution to core inflation, rising by an average of 11.3% in May on a year-on-year basis, reversing the decline in crude prices in early 2020. But this would be just the primary effect. The secondary effect is more damaging as it percolates into prices of other goods, too, by way of transport, logistics and freight costs. A part of the inflation that is being witnessed in the retail prices of milk, vegetables and edible oil can be attributed to the high freight costs.
Yet, the dominant view is that the RBI is moving too independently, and isn’t seeing what everyone else is experiencing. Governor Das sees the inflationary pressures as a “temporary hump”, which should moderate in the third quarter. Food and fuel account for 53 per cent of the CPI basket, but its direct influence on monetary policy is limited which is why the RBI governor seems so unperturbed. The governor has also made his stance clear: nurturing growth as a priority over inflation.
Das’ ultra dovish comments, however, are in contrast with the growing concerns about high inflationary pressures brewing within the six-member Monetary Policy Committee (MPC) — which has so far been unanimous in its policy prescription — even before the May CPI data were available. RBI MPC member Mridul Saggar and external member Jayanth R. Varma have warned against the unhinging of inflation expectations, with the former even stating that had it not been for Covid, the policy stance should have been neutral “long back”.
“Even as the governor seems to suggest that high inflation is a temporary phenomenon, we are more concerned. Coupled with rising supply-side (higher input costs) and demand-side (reopening) pressures, we now expect CPI inflation to average 6.1% y-o-y in 2022 and headline inflation to inch up higher to 6.5% y-o-y in June. Our view remains that the RBI and its MPC will likely pivot due to inflation remaining stubbornly high,” pointed out Nomura's chief economist Sonal Varma.
Going forward, seasonal effects should further push up prices of perishables such as vegetables and fruits, while rising international oil prices will add to operational and logistical costs of non-perishable items. Moreover, experience from the first wave suggests that lockdown-related inflationary pressures are typically sticky. Currently, there is no evidence of a demand-pull pressure. The output gap is deeply negative, unemployment is high and wage growth is weak. Economists believe even if commodity prices top out soon and supply-side disruptions are addressed owing to easing of mobility restrictions, price pressures are likely to build up further — not from a demand push, but due to a need for companies to compensate for the lost profit margin.
“Any likely recovery in demand would create room for the corporate sector to compensate for the margin compression experienced over what has been nearly a year, resulting in sticky CPI levels. In the ‘margin increase’ related basket, we include goods for which demand was low during the lockdown, leading to an increase in prices to make-up for lost revenue on reopening such as clothing, footwear, etc,” explained Bajoria.
To be sure, cuts in fuel taxes apparently are not planned even though the RBI has repeatedly urged the North Block to lower excise duties.
“The phenomenal rise in excise collections last year was due to higher duties as consumption was lower. For example, in FY21 consumption of petrol was around 3,900 crore litres of petrol and 8,600 crore litres of diesel. The combined consumption is around 12,500 crore litres and hence a Re. 1 reduction in taxes will mean just Rs 12,500 crore of outflow. This can be a big compromise,” according to Madan Sabnavis, chief economist, Care Ratings.
While there is a fiscal cost for sure, he added, allowing inflation to go unchecked is a problem as it has also distorted the bond market with the MPC firm on managing the yield curve.
Now the policy normalisation part. Since March 2020, policy rates are sliced to the bone by 115 bps, yet private investment remains poor. Nomura expects policy normalization will begin in Q4, with liquidity normalization, a 40bp hike in the reverse repo rate, and a cumulative 75bp of repo rate hikes in 2022.
"On timing, the governor's comments suggest December is more likely than October. The dovish tilt suggests risks are skewed towards a later withdrawal. In our view, inflation expectations are not as well anchored in India and looking through inflation for too long will risk even higher inflation in the medium-term, and more policy catchup in 2022", it said in a note.
The next couple of CPI readings will be important for establishing the extent to which the flare-up in May is reversed. The keenly-watched June CPI numbers are expected to be announced on Monday.