Dharmakirti Joshi, Pankhuri Tandon write: Fighting the Hydra of Inflation
After the unleashed virus, soaring prices are the new global scourge. Systemically important central banks that viewed the steady rise in inflation as transitory — caused by post-pandemic supply shocks — are now struggling to bottle up the genius. Expectations that commodity and oil prices would cool in 2022 as the pandemic ebbs have been belied by the Russia-Ukraine conflict, which has exacerbated existing pressures. New lockdowns in China are also prolonging pandemic-induced supply chain bottlenecks.
What central banks like even less is having to deal with rising inflation in times of weak growth. Because the main tool they have to fight it – rising interest rates – can be recessive.
Cut to India, and you can see domestic inflation going mainstream in FY2023. In just two months (between February and April), the Reserve Bank of India (RBI) has revised its inflation based on the consumer price index (CPI). expected 5.7 percent from 4.5 percent for this fiscal year.
CPI inflation averaged 6.3% from January to March 2022, above the RBI’s target range of 2-6%. The RBI expects inflation from April to June at 6.3%. A quarter more above the 6% mark, and the central bank would owe the government an explanation.
But inflation in India—unlike in advanced countries where large fiscal stimulus measures have also contributed to higher prices—has been largely “imported” via exogenous supply shocks. Relevantly, private consumption demand continues to be the weakest link in gross domestic product (GDP) growth so far. What is remarkable, however, is that the drivers of inflation are changing.
In fiscal 2021, inflationary pressures came largely from food and to some extent from the core (which excludes fuel and food). At the time, fuel inflation was pretty benign. In fiscal year 2022, crude prices have hardened to become the new driver. Core inflation has firmed up further. But lower food inflation compensated for this, so that headline inflation was lower at 5.5% compared to 6.2% the previous year.
What makes this fiscal situation worrying is that all three point firmly in the same direction – upwards. Truly, the hydra of inflation is on the horizon. A breakdown by component helps clarify this.
Fuel inflation, which has been in double digits for a year, shows no signs of slowing down. Energy prices rose sharply in everything from crude oil to coal and natural gas. The cut in gasoline and diesel excise duties in November 2021 is insufficient to bring fuel inflation down, should crude prices stay above $90 a barrel this fiscal year. We also expect a delayed pass-through from last year, as gasoline, diesel, liquefied petroleum gas and compressed natural gas prices remained unchanged between November and March, despite rising international prices.
Food is the most volatile component and the biggest driver of CPI inflation, taking up 39% of the weight of the average consumer basket. On the positive side, India looks set to enjoy a fourth consecutive year of normal monsoon and still has good buffer stocks of rice and wheat. But the monsoon has not yet played and its distribution is still a bit of a wild card. Some other factors that negatively affect production and prices, such as the recent heat wave which is expected to impact wheat yields this year, are worsening.
What is certain, however, is the rising cost of food production. Prices for fertilizers, pesticides, diesel and animal feed are all up sharply. This will lead to higher minimum support prices (MSP) during this financial year, as they are indexed to the evolution of production costs. MSPs also take into account international price trends.
The prices of wheat and sugar (India’s main exports) and vegetable oils (a major import) soared after the Russian-Ukrainian war. Already expensive edible oils are set to become even more expensive, with Indonesia’s recent ban on refined palm oil exports adding to the pressure. No wonder then that food inflation is expected to rise.
Finally, underlying inflation, a barometer of demand pressures, will continue to climb despite a weak demand environment, thanks to the persistence of supply shocks.
For producers, the rise in international prices of energy and metal raw materials since the war has caused more suffering. Average wholesale price-indexed (WPI) inflation last fiscal year was 12.9%, the highest in 30 years, and non-food WPI inflation was 15.7%.
But a weak and uneven recovery in demand meant producers had limited ability to pass cost pressure on to consumers. This pass-through was partial at best: for most goods, CPI inflation was well below last year’s corresponding CPI. The pattern of recovery is also uneven across different segments, with contact-intensive services lagging behind formal industry and rural wages slowing relative to rising wages in the urban formal sector.
All this is reflected in the pattern of transmission to consumers. CPI inflation for services at 5.1% in fiscal year 2022 has not increased to the same extent as for goods at 6.2% (under the basic category, at the exclusion of petrol and diesel). Also within goods, a greater pass-through is seen in goods consumed by high-income segments, such as passenger cars, paints and packaged food.
But contact-based services will catch up sooner or later, as restrictions will be a thing of the past. Additionally, PMI data from S&P Global shows that input cost pressures have been stronger for services than for goods. This will lead to increased pressures on underlying inflation.
The last time we saw such widespread inflationary pressures was after the global financial crisis. CPI inflation in India averaged 9.2% annually between FY 2012 and FY 2014. Food inflation averaged 9.8% and core inflation averaged 8.6% . In FY2022, these were 3.8% and 6.0%, respectively. Together, they have a weight of 86% in the CPI basket. Fuel inflation was slightly lower at 10.9% (fiscal years 2012 to 2014) compared to 11.3% (fiscal year 2022). The difference this time around is consumer demand, which remains weak and will limit the magnitude of the pass-through.
Forecasting inflation in these uncertain times carries risks. The RBI has predicted consumer inflation of around 5.7% for this financial year, while professional forecasters see it at 5.6%. The odds are currently in favor of higher inflation and a rate hike in June.
This column first appeared in the print edition of April 28, 2022 under the title “The Hydra of Inflation”. The authors are Chief Economist and Economist at CRISIL Limited