Higher Core Elements In Inflation Could Narrow Scope For Monetary Easing

The latest RBI study on India’s food inflation highlighting its persistence and impact on both the headline and core inflation is a message that the central bank’s combat against high inflation and rising cost of living is not over yet. The problem of persisting inflation amid an extremely torpid consumption demand and rapid real production growth is enigmatic. The huge gap between the narrative of strong growth and frail volume growth of most FMCG, retail, and durable goods companies is glaring. Hence, it begs a comprehensive understanding.

Over the past four years, India’s headline inflation averaged 6% (CAGR), driven significantly by high and sticky food inflation averaging at 6.4%, while the core inflation (excluding food and fuel items) stood lower at 5.6%. Contrastingly, real personal consumption expenditure averaged 3.5% during the four quarters through September 2023 despite the exuberant retail lending.  

RBI in its latest research, titled 'Are food prices the ‘True’ core of India’s inflation', points towards food inflation dynamics characterising properties of core inflation. While food inflation is generally seen as transient, driven by short-term supply-side factors, in a significant departure from the common understanding, it is now also attributed to demand-side factors.

If that is indeed the case, then monetary policy will need to consider high food inflation as an important variable to avoid any de-anchoring of inflation expectations. As RBI’s degree of freedom diminishes, it could defy the early rate easing priced in by the markets.

The broader message that the higher and sticky food inflation is structural, aligns with our earlier assessment of two-track inflation characterising the diverging trends between the softening consumer product inflation and structurally higher food inflation.

As per the study, food inflation contributed 43% of average headline inflation during 2016-2023, with vegetable inflation dominating all other sub-groups to contribute 38% of the variance in headline inflation; 30% of the total variance collectively came from other sub-groups.

Large food price shocks cause large movements in headline inflation, with certain food sub-groups contributing excessively. Non-cyclical factors like weather, supply conditions, international prices, and availability determine about 90% of the food inflation, with the rest driven by demand factors.

Certain food sub-groups that exhibit core-like properties (prepared meals, non-alcoholic beverages, milk, cereals, oils & fats, pulses, and spices) display a higher persistence than vegetables, reflecting global influence and structural domestic supply bottlenecks.

Such persistence creates a spillover effect on non-food inflation through inflation expectations and cost-push pressures. Normally, deviations in food prices converge to non-food prices (core component) within a year. However, as the pace of adjustment is low, large and persistent food price shocks begin to influence non-food prices (or core inflation).

A persistent food price shock warrants monetary policy action to avoid de-anchoring inflation expectations. If the monetary policy chooses to neglect this, inflation expectations could get unanchored, generalising inflation as a result.

While the RBI’s paper draws inferences from the post-facto statistical dissection of inflationary trends, it lacks the explanation behind the shifting dynamics. Here are some explanations from our research:

1. The study fails to explain relevant demand impulses that cause food inflation to stay higher. We have attributed this to the rising proportion of working-age population dependent on rural occupation including agriculture, which is corroborated by the latest Periodic Labor Force Survey (PLFS 2022-23). Given that average food consumption is higher in rural areas than the urban, the rising ruralisation trend is causing a structural increase in demand for food, specially food grains.

2. The PLFS data also indicates a contraction or stagnancy in the average real income of an Indian worker over the past four years, including a regular wage, casual wage, and a self-employed earner. The worsening household income situation has led to a downtrading in consumption patterns, including higher spending on food. Thus, despite record foodgrain production, run down of government buffers, ban on exports, and open market sale of foodgrains, food cereal inflation remains high.

3. Rising pricing power for large firms as a fallout of multiple shocks like demonetisation, GST implementation, and the Covid lockdown has also meant that prices of consumer products have averaged more than what would be commensurate with flattening volume growth.

The RBI’s research hints at the limitations the central bank may face in reverting to an accommodative stance. Food inflation rebounded to 8.7% in December 2023, propelling the headline inflation to 5.8%, with the four-year CAGR at 6%—a divergence from the recent easing inflation trends in developed markets.

With the RBI attempting to slow the exuberant retail lending, amid faltering household savings and inflation way above its 4% target, its degree of freedom is significantly narrowed. Moreover, the government’s extension of the free-food distribution programme for the next five years coupled with food inflation implies higher food subsidy allocation, which could impact the fiscal math and G-sec yields.

During the current phase of monetary policy normalisation, the RBI has already shifted from using rate hikes to liquidity tightening, with overall regulatory tightening intended to slow banks’ balance sheet expansions. Thus, by acknowledging that high inflation is structural could induce a market reset on rate-easing expectations.

Aligning with the change in expectations of the US Fed adopting an early easing cycle, Indian markets too priced in a sympathetic monetary easing, thereby bloating valuations, particularly for rate-sensitive sectors such as real estate, NBFCs, and banks. As reality dawns, these sectors may experience a reset in expectations, both in terms of outlook and valuations. Conversely, higher food inflation should also imply a shift in terms of trade in favour of the agriculture sector and industries dependent on it.

Dhananjay Sinha is co-head of equities and head of research, strategy and economics, Systematix Group.

The views expressed here are those of the author and do not necessarily represent the views of BQ Prime or its editorial team.