Understanding the inflation numbers | Number Theory

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October’s retail inflation number is a record low, just 0.25%, in the current Consumer Price Index (CPI) series. October is also the ninth consecutive month in which headline inflation has stayed below the 4% target of the Reserve Bank of India. What should one make of the latest inflation number? What does it tell us about the Indian economy and policy direction going ahead? Here are three charts which summarise the situation.

October is the ninth consecutive month in which headline inflation has stayed below the 4% target of RBI. (Bloomberg)

Understanding the inflation numbers

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  Lowest ever inflation is primarily a seasonal phenomenon

  In India, seasonal factors such as food or fuel prices are often big drivers of inflation. This is why it is important to compare the trend of headline inflation number with the core or non-food non-fuel part of the CPI basket. While headline inflation has collapsed to a historic low of 0.25%, core inflation, as seen in Centre for Monitoring Indian Economy (CMIE) data, is at 4.3% which is far from insignificant. More importantly, while headline CPI has largely shown a falling trend in the last few months, core inflation has been broadly stable in the ballpark of 4%-4.5%. This shows that a lot of the current low inflation environment is driven by seasonal factors (more on this later) rather than some structural deflation like scenario in the non-farm economy.
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  What matters is that the real repo rate is at an all-time high in the current CPI series

  What makes inflation an important policy variable today is the fact that India has formally adopted the inflation targeting framework for its monetary policy. This means that repo rates, or the rate at which the RBI lends money to the banks (or the policy rate), and by extension retail lending rates, are tied to inflation numbers. With inflation collapsing to just 0.25%, real repo rate – nominal repo rate minus inflation – in October now stands at 5.25%, the highest monthly number since January 2012 since when we have monthly inflation data in the current CPI series. The fact that real repo rates have been increasing continuously for a long time now will strengthen the case for a rate cut by the RBI’s Monetary Policy Committee when it meets on December 3. Given the fact that the MPC did not reduce interest rates in its October meeting and even maintained the policy stance as neutral, this number will only increase the pressure for a rate cut on December 3.
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  The evolving terms of trade in the economy

  Seasonality or lack of it is not the only issue when looking at food and non-food inflation numbers. They also matter because inflation also serves as an arbitrage for terms of trade in the Indian economy. If food prices are rising at a higher rate than non-food prices then farmers stand to see an improvement in their terms of trade, which along with other things, can also lead to a strengthening of rural incomes and therefore demand. What the recent collapse in food inflation amidst a largely steady non-food inflation means is that terms of trade have likely significantly worsened for the rural sector in the Indian economy. To be sure, the difference between food and non-food inflation numbers needs to be read carefully rather than mechanically. This is because even the headline food inflation number hides behind it significant variation in different sub-categories. While vegetable prices have contracted by more than 27% on an annual basis in October, the edible oil category saw an 11% increase in prices.