Monetary policy has an inflation dilemma - Hindustan Times
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Monetary policy has an inflation dilemma

Feb 26, 2024 12:10 PM IST

Faced with low core inflation and high food inflation, RBI will likely tilt towards a longer disinflationary stance, to achieve the 4% CPI rate

Inflation, though moderating from its recent highs, continues to hover above target in most of the countries, including India. The last mile of disinflation towards the policy target is always challenging but other interesting nuances are seeping into the incoming global inflation data. Goods inflation has collapsed with improvement in supply-side factors, but services inflation appears to be stickier. In some parts of the world, growth is turning out to be more resilient, leading to risks of reversal in the falling inflation trend. However, there are others who are dealing with simultaneous recession and above-target inflation. Monetary policy easing has barely started around the world, but expectations are building about a series of rate cuts as the year progresses.

India’s recent inflation has been a tale of two prices. Food inflation remains elevated at 7.6% but core inflation has dropped sharply to 3.6% in January 2024 PREMIUM
India’s recent inflation has been a tale of two prices. Food inflation remains elevated at 7.6% but core inflation has dropped sharply to 3.6% in January 2024

India’s recent inflation has been a tale of two prices. Food inflation remains elevated at 7.6% but core inflation has dropped sharply to 3.6% in January 2024. For perspective, core inflation has been sticky in the past, averaging 6% in 2021 and 2022. The problems of food inflation are more visible in 2022 and 2023 when it has averaged 6.7%, compared to just 3.6% in the five years preceding the pandemic. This prompts us to investigate both the questions—why is core inflation falling sharply and why is food inflation persisting?

To better appreciate the extent of the decline in core inflation, it makes sense to observe the month-over-month (m-o-m) change in this index. Core CPI rose by only 0.24% m-o-m on average in October-January FY24, almost half of the 0.48% average in FY23 and 0.40% pre-Covid average. The decline is also quite broad-based as inflation momentum is not above 6% in even one of the 24 sub-categories of core inflation and is above 5% in only two of the 24 sub-categories. While part of the decline could be explained by the supply chain easing-led input price disinflation, the quantum of fall in core inflation momentum seems perplexing in an environment of repeated positive GDP growth surprises.

In theory, when GDP growth exceeds potential growth, the output gap turns positive and causes inflationary pressures. The Reserve Bank of India (RBI) analysis seems to suggest that this relationship between the output gap and inflation (known as the slope of the Philips Curve) has been steadily weakening over the last decade. In fact, though the output gap kept on improving between FY15-FY19, the core inflation momentum was not unidirectional.

However, a deeper dive into the issue suggests that if the positive output gap is caused by higher consumption, then the chances of core inflation gaining momentum are stronger. The correlation between investment and core CPI is generally weak may be because higher investments widen the supply frontier and reduce price pressures. Probing a little more, we find that urban consumption has a higher correlation with core inflation than its rural counterpart. This could partially be because the wage-price spiral is more prominent in urban rather than rural.

Our index tracking high-frequency urban consumption data has been consistently falling since mid-2023 and suggests that urban demand growth could be just around pre-Covid levels. This likely explains the continued fall in core inflation momentum beyond the pass-through of input price deflation. In fact, with investment growth (9.4% in FY24E) running strong, supply-side constraints might be easing and accentuating the demand-supply gap. This combination of weak demand and better supply side probably best explains the historically weakest core inflation momentum and also helps explain the manageable current account balance picture. The current cyclical position is quite different from past trends where the closing down of the demand and supply gap caused core inflation to inch up and the current account deficit to widen.

These positive developments on the core inflation front have been overshadowed by a stubborn food inflation which also demonstrates an uncharacteristically high level of volatility even beyond the usual suspects like vegetables.

Excluding vegetables, food inflation has averaged 6.8% in the last four years versus only 3.1% in the four years before that. It is heartening that in January 2024, the ex-vegetable food inflation dropped to its post-pandemic low of 5.1% but there are still wide divergences in the internals. Pulses (20% year-on-year), rice (12%), spices (16%) inflation remain extremely elevated though some softness is emerging on prices of protein items and wheat. While fingers are crossed on the weather pattern over the next two months, which will determine the fate of the winter crop, the government is continuing with supply-side measures like conducting open market sales of wheat and rice and imposing limits on stockholding. Global food prices (UN FAO Index) are in deflation now for more than a year after the sharp spike in 2022. Hopefully, with a lag, this feeds into India’s food inflation as well, especially if El Nino conditions retreat by the time of the summer crops.

It is well known that RBI’s monetary policy can do little to influence food prices but still, the RBI cannot just focus on the core inflation since the policy framework is centred around the headline CPI. The RBI is worried about the generalisation of food inflation to core, and governor Shaktikanta Das has re-emphasised the 4% headline inflation target as the necessary bedrock for sustainable economic growth. Based on our analysis, the RBI need not be too concerned about the impact of high GDP growth on core inflation at this point. With demand momentum being tepid and both fiscal and monetary policy being in contractionary mode, any upside surprise on core inflation can only come from a return of supply-side shocks like the disruption in the Red Sea route. The divergence between low core inflation and elevated headline is emerging as a policy dilemma for the RBI but they will likely tilt for a longer disinflationary stance to achieve the 4% CPI target. Markets might have to be patient on policy easing hopes.

Samiran Chakraborty is managing director and chief economist India, and Baqar Zaidi is economist, Citigroup. The views expressed are personal

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