Inflation is dipping, but RBI may not slash rates

Consumer inflation expectations have also declined compared with the recent past. But the central bank will be cautious in letting its guard down too

The latest retail inflation print showed the consumer price index (CPI) slowing to 4.7% year-on-year in April, well within the Reserve Bank of India (RBI)’s target band of 2%-6%. Headline inflation has also slowed over a period of three months. While the near-term trajectory of inflation is downward, the medium-term path is unclear as the risk of a disruptive El Niño could put pressure on food prices towards the end of 2023.

Inflation in perishables is beginning to inch up from seasonal effects (prices for fruits and vegetables typically rise during the summer months), while high fodder costs are keeping milk inflation elevated. (REUTERS)

Three factors are driving inflation lower in the near-term.

First, the imported component of CPI inflation has fallen sharply, driven by the decline in international prices of energy, fertilisers and metals from their 2022 highs. Second, food inflation is trending lower as prices of non-perishables are no longer rising. Food inflation has halved to 4.2% in April, from a peak of 8.4% in September 2022. That said, inflation in perishables is beginning to inch up from seasonal effects (prices for fruits and vegetables typically rise during the summer months), while high fodder costs are keeping milk inflation elevated. Third, significant base effects will continue to support a moderating trend in the headline rate in the near-term.

Further, there is room for reductions in the administered prices of several fuel products. For instance, international LPG and crude oil prices have fallen sharply vis-a-vis last year, but retail prices for motor fuel and household cooking gas have not reduced. We estimate that if retail petrol prices were reduced by 10%, this could shave almost 20 basis points (a basis point is a hundredth of a percentage point) from headline inflation directly in FY2023-24, and by a further 10-20bps from second-order effects. There could be a larger downside if the government also lowered cooking gas prices at the same time.

While the above factors provide reasons for optimism on near-term inflation, uncertainty about a likely El Niño poses some upside risks to food prices towards the end of 2023. The India Meteorological Department is forecasting a normal monsoon this year, with a likely El Niño during the period. Historically, an El Niño event has exhibited a strong correlation with deficient monsoon rainfall: All years of deficient monsoons since 1950 were El Niño years (but the reverse is not true). Some comfort can be drawn from the fact that the sensitivity of India’s agriculture output to rainfall has reduced over the past few decades, as the share of irrigated areas and capacity of water reservoirs have both risen. But kharif output has typically fallen during deficient monsoon years, hence the prices of kharif crops, particularly rice, will need to be monitored.

The ultimate impact of El Niño on food inflation will be determined by a combination of factors: The intensity of El Niño; the geographic distribution of monsoon rainfall; the size of government food buffer stocks; supply/demand dynamics; and, to an extent, the level of water reservoirs. The first two factors are weather-related and hence will remain uncertain. Buffer stocks of wheat and rice have, in the past, allowed government interventions to temper inflationary pressures (the latest example being earlier this year for wheat). Estimates of demand/supply levels show that gaps between the two have narrowed for food grains in the past few years, but remain large for vegetables and fruits, and, especially, oilseeds, making these items more prone to inflationary spikes. Thus, food grain inflation may be more inherently manageable (given buffer stocks and barring sharp undershooting of production targets) than inflation in perishables, such as vegetables or imported commodities such as oilseeds.

Another risk factor that may create headwinds to moderating headline inflation is stickier core inflation. Even though core inflation has slowed in year-on-year terms, helped by base effects, sequential price rises have been persistent. This is evident in services, particularly housing, health and education, and to an extent, some core goods, such as personal care categories. Though input costs have fallen for producers (largely from lower imported costs and easing energy inflation), we think a pass-through to retail prices will take time, as producers are likely to look to rebuild margins. Thus, the re-emergence of pricing power amid robust growth may mean the easing of core inflation will likely only be gradual.

Inflationary shocks since the Russia-Ukraine war last year have largely receded in the past few months. RBI surveys show firms expect input and output prices to moderate going ahead. Consumer inflation expectations have also declined compared with the recent past, which is likely to offer comfort to RBI. But we still think the central bank will be cautious in letting its guard down too early on inflation. High-frequency indicators show economic activity largely holding steady, thus there would seem few reasons for growth concerns to prompt interest rate cuts in the near-term, especially considering that the impact of rate hikes has yet to play out fully through the economy.

Rahul Bajoria is a managing director and head of EM Asia (ex-China) Economics at Barclays, and Amruta Ghare is a regional economistThe views expressed are personal