India: Inflation undone? Some inflation worries highlighted earlier have come to pass

As demand for goods and services pick up gradually (though worth noting that we are not forecasting a rapid rise in demand like last year), producers may feel more confident about passing on raw material cost increases to output prices, pushing core inflation higher.

By Pranjul Bhandari, Aayushi Chaudhary & Priya Mehrishi

There have been several global and domestic shifts in the inflation ecosystem we had gotten used to in the last several years. On the global front, there is a raging debate on whether current price pressures are temporary or permanent. There are many moving parts here. One, global commodity prices have risen by an average of 80% since the trough of April 2020, hurting corporate margins and threatening to spill over into consumer prices, though some believe that we may not witness a new super-cycle from here on. Two, the world has seen large, long-lasting and unconventional fiscal and monetary easing, the lasting impact of which remains unknown. Three, some advanced economies are facing a shortage of right-skilled labour and components, pushing up prices. Finally, the global economy is too dependent on complex supply chains, that have helped keep consumer prices low in the past, but are coming under pressure now.

Having said that, as discussed by Frederic Neumann, for most of Asia, inflation risks are on the ‘costpush’ side, with little evidence yet of ‘demand pull’ from accelerating consumption. As such, whether these price pressures are temporary or permanent, is up for debate.

On the domestic front, some inflation worries we highlighted last year have come to pass.

One, real rates, which have been a driver of inflation in the past (for instance, the FY09-FY11 period), have moved into negative terrain after six long years.

Two, there are risks that inflation expectations could get unanchored. Our inflation model suggests that inflation expectations (‘backward’ and ‘forward’ combined) are an important driver of inflation, explaining about 75% of the trends in inflation. With real rates falling, expectations will face their biggest test of the last few years. Were they subdued because other factors were supportive or had they truly become anchored at low levels? Recent data show that some inflation expectation series have ticked up slightly. What underlying message are the recent inflation prints giving? Inflationary pressures in India can be ascertained at three levels—at the wholesalers (WPI inflation), intermediate costs (logistics, transportation and profit margins), and price to consumers (CPI inflation).

During the first pandemic wave last year, WPI inflation was subdued on the back of falling global commodity prices. Inflationary pressures, instead, were rife at the intermediate cost and CPI inflation level, led by logistics and transportation bottlenecks (that were caused by the national lockdown).

This year is different. Inflationary pressures seem to have moved down the chain to WPI inflation. This is consistent across all the key categories—food, fuel and core components. And within WPI inflation, input prices are rising much faster than WPI output prices. Interestingly, the same trends are visible in the PMI indices: input prices are rising faster than output prices.

Producers do not seem to be passing much of the rise in raw material costs to output prices, perhaps worried that the already uncertain demand could weaken further. We had recently calculated that in periods of rising input costs, firms tend to pass on 60% of the price pressures to consumers. Trends from the last six months show that this time around they seem to have passed on only half of that to consumers, taking the rest as a hit on their profit margins.

What does this mean for future inflation prints? There are signs that the second pandemic wave has peaked. Some states are also considering steps on rolling back the local lockdowns that were implemented.

As demand for goods and services pick up gradually (though worth noting that we are not forecasting a rapid rise in demand like last year), producers may feel more confident about passing on raw material cost increases to output prices, pushing core inflation higher.

Furthermore, as the vaccination drive reaches critical mass, by end-2021, as per our current expectations, services inflation could start to rise too. As discussed before, supply of services takes time to augment, making high services inflation sticky. To summarise, as higher raw material costs are passed on to consumers, core inflation could rise, particularly in 2HFY22. With more pass-through of input cost pressures to output prices over time, CPI core inflation pressures could be higher in 2HFY22 (6% y-o-y) compared to 1H (4.7% y-o-y). For the year, we forecast core inflation at 5.4% y-o-y (above 4% for a second year in a row).

On the food front, price pressures for cereals and vegetables are contained. But that for oils, eggs, meat and fish are on the rise. We expect price pressures for manufactured food to be higher in 2H compared to 1H, though primary food products are likely to remain uniform through the year. For the year, we forecast food inflation at 4.2% y-o-y (versus 7.4% last year when supply disruptions had risen).

In view of rising oil prices, we forecast transportation inflation at 7.5% y-o-y and fuel and electricity inflation at 9.9% y-o-y.Putting it all together, we expect headline inflation at 5.2% y-o-y. Both headline and core average-of-the-year inflation is forecasted at above the 4% target, but lower than the 6% upper limit.

In FY21, RBI was faced with conflicting objectives on inflation, bond yields and the rupee (also known as the impossible trinity). It bought dollars to keep the rupee for strengthening too much in the midst of a large BoP surplus and an economic slowdown. It bought bonds to keep bond yields from rising too much at a time public sector borrowings had risen to record highs. But all of this infused excess rupee liquidity into the banking system, which over time can stoke inflation and other financial imbalances. These conflicting objectives are likely to be around this year (FY22) as well, and RBI will have to juggle carefully. Having said that, it could get some helping hand along the way, which we believe could help it to gradually shift focus to inflation, as the year progresses.

On the BoP front, as the current account moves from surplus to deficit, the overall BoP surplus is expected to fall in FY22 (even if capital inflows remain elevated). With that, RBI may not have to buy as many dollars as it did last year, to keep the rupee from appreciating sharply. This means, as the year progresses, RBI may find some space to shift focus more squarely on its inflation objective, by gradually lowering the surplus liquidity in the system. RBI would still need to buy government bonds to assist the government in its borrowing programme. There are risks that the second pandemic wave raises the fiscal deficit, leading to more demand for RBI bond purchases.

However, the Centre may find some buffer from large carry over cash balances at end-FY21 (March 2021). Cash balances at the end of FY21 were c`2.5trn, almost double the recent years’ norm. This means that some of the unbudgeted rise in fiscal deficit could be funded by these carry over cash balances, and may not necessarily translaate to higher-than-budgeted borrowings, one-for-one.

All told, if the need to buy dollars is lower than last year, RBI could use the space to gradually shift focus on inflation, and plan a gradual exit from loose monetary policy. But how would that unfold in the face of a delicate growth recovery?

The surest driver of cyclical recovery is vaccination, which we believe will reach critical mass by endCY2021. In fact, that may even give producers the confidence to pass on high raw material costs to consumers, thereby stoking inflation.

That means RBI may have to embark on policy normalisation this year itself. The monetary easing of FY21 had three components—liquidity infusion, accommodative stance, and rate cuts. We believe the policy normalisation of FY22 must also touch upon each of these three, in order to be effective.

For now, by October 2021, RBI could start to gradually lower the surplus liquidity, and raise the reverse repo rate (currently at 3.35%), followed by a change in stance to neutral. The aim of this, we think, should be to gradually push up short-end rates towards 4%, so that real rates don’t remain hugely negative for long.

Having said that, we think that an increase in the benchmark repo rate, currently at 4%, can wait for longer, perhaps once there are surer signs that the private investment cycle is rising.

In the upcoming June 4 policy meeting, RBI may want to sit tight in view of the still high pandemic cases. This would entail keeping rates on hold, stance accommodative, and liquidity in surplus. The one change would likely be a markdown in GDP growth forecast (from 10.5% for FY22 to perhaps high single digits, accounting for the economic cost of the second pandemic wave). There are likely to be a few regulatory steps in the June mix. But several have already been announced recently, for example a restructuring 2.0 scheme and a Covid-19 loan book. And new steps from here may not have the same bang for the buck. Instead, we think government policy (both fiscal and reforms) should focus on the growth objective from here on.

Edited excerpts from HSBC Global Research’s report dated May 27,2021

Respectively, chief economist (India), economist, and associate, HSBC Securities and Capital Markets (India) Private Limited