Commodity prices are falling, but the inflation scare isn’t over. The combination of rate hikes and a competitive rupee could slow inflation, while keeping growth humming
In the run-up to the Reserve Bank of India (RBI) policy announcement on August 5, we answer the five most pressing questions.
believe that if RBI continues to press ahead with front-loaded rate tightening, instead of easing tightening efforts on the back of the recent fall in commodity prices, it can gain credibility points. (Mint Archives)
One, is the inflation scare really ending? The short answer: Not yet. Yes, commodity prices have fallen 20-40% recently, and consumer price inflation looks to have peaked in April. But we still expect inflation to stay far above the 4% target for a considerable period. Here’s why.
One, core inflation — which excludes volatile food and fuel — is high. Two, climate change makes it harder to predict food and fuel inflation. Rain and reservoir trends are changing, which, in turn, are changing sowing and seasonality patterns in food prices. Three, high input costs are yet to fully filter through to final prices for food, services, and energy. Four, inflation in India tends to be sticky. Through the pandemic, large firms have got larger, gaining pricing power, which could keep them from cutting prices when input cost pressures abate. Five, with India’s balance of payments going into deficit, the rupee is gradually depreciating, which is likely to have an inflationary impact. Six, fiscal policy has sought to offset the global economic shock over the last few months via high fertiliser subsidies and oil tax cuts which may add to inflation pressures later down the road. Considering all of this, we expect Consumer Price Index (CPI) inflation to fall from 7.8% in April to around 6% by December, but still quite some distance away from the 4% target.
However, an opportunity has emerged. We believe that if RBI continues to press ahead with front-loaded rate tightening, instead of easing tightening efforts on the back of the recent fall in commodity prices, it can gain credibility points, make a serious dent in inflation expectations, and potentially succeed in ending the inflation scare.
Two, what will slow down inflation over the next year? Lower food inflation. More specifically, robust rain and reservoir levels, excess rice stocks in the granaries, and a softening in global food prices will be the main short-run drivers. Government policies could play an important role over the medium-term. On the other hand, core inflation could stay elevated as large firms exercise their growing pricing power by keeping prices high and as loose fiscal policy keeps spending up.
And the risk with food prices being the key driver of disinflation, even while core inflation stays high, is that the overall inflation trajectory remains vulnerable to supply shocks, such as heatwaves hitting harvests, which are on the rise. Steps to lower core inflation may require not just more upfront rate hikes, but also reforms to improve the efficiency of key inputs like land and labour.
Three, how long will external finances remain under pressure? Probably for quite some time. If oil prices remain in the $100/barrel ballpark this year and next, the import bill will likely remain elevated.
Meanwhile, some exports could begin to weaken as global growth slows. We are already seeing export volumes begin to fall. Digging deeper, we find that exports made with low-skilled labour have led the decline.
Then, there are important changes to capital flows. While most people focused on the around $30 billion of portfolio outflows this year, there is a story emerging in foreign direct investment (FDI), particularly money flowing into tech startups. We estimate this has already slowed by about 40% since last year.
Portfolio inflows come back as soon as valuations begin to look attractive again (in fact, last week, saw some inflows). But FDI is relatively slower to leave and slower to return. All of this could keep external finances on the weaker side, putting pressure on the rupee to weaken, and requiring that foreign exchange reserves aren’t used up too quickly.
Four, is investment rising? This is an important question for RBI, which has kept a firm eye on ensuring growth while trying to tame inflation.
Our sense is that there is some capital expenditure (capex) taking place, but it’s mostly to replace equipment, not for a new investment cycle. Looking closer, the main constraint to capex over the last decade was overleveraged companies and banks stuffed with bad loans, but that’s improved substantially now.
The main problem is macroeconomic uncertainty — high inflation is denting purchasing power. From that lens, rate hikes that lower inflation could also set the stage for a new capex cycle.
Five, what should RBI do on August 5? A two-fold strategy could help to simultaneously address India’s external and internal imbalances.
One, ensuring a competitive rupee can help secure growth. After all, exports have been a strong contributor to India’s Gross Domestic Product (GDP) growth recently, contributing about 50% to the overall GDP growth number last year.
Two, raising rates to address inflation pressures, including the pressures emanating from a weaker rupee. We believe that RBI should take the repo (policy) rate to 6% by December this year, by raising rates in each of the three policy meetings remaining in 2022, including a 40 basis points hike at the upcoming meeting on August 5.
Pranjul Bhandari is managing director and chief India economist, HSBC India
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