RBI downplaying inflation, but for how long it can?

NEW DELHI: RBI governor Shaktikanta Das has been dismissing suggestions that the country will likely see a burst of inflation later this year. However, he may be forced to rethink soon. The signs of looming price instability, aka inflation, are all around us.

It is crucial for the central bank to keep the inflation below 6 per cent, but the passthrough of decade-high wholesale price inflation has led to a steady increase in retail inflation.

In May, retail inflation, which is measured by the Consumer Price Index (CPI), surged to 6.3% and economists say there is a strong likelihood that retail inflation in June will rise further, with core inflation likely to remain elevated above 6 per cent levels.

Higher recovery in emerging markets has bumped up global demand and has kept international commodity prices at higher levels. Not only in petroleum products, but there has also been a broad-based surge in the prices of metals (particularly steel), cotton, edible oil and chemicals.

The rally in crude prices since end-2020 has added to cost pressures, with Brent crude hitting USD 72 a barrel in June from USD 33 in March 2020. Adding lockdown-led supply curbs to the mix, there is a perfect recipe to uncomfortable inflation.

"Increase in commodity prices is having a direct effect across key subcomponents of the CPI. Surge in food prices over the past 2-3 quarters were driven by non-perishables, mainly pulses and vegetable oils, both of which are heavily influenced by global prices. Similarly, among the components of core CPI, clothing and footwear are showing evidence of rising imported price pressures," says Rahul Bajoria, chief economist at Barclays India.

As crude prices rose, India’s retail fuel prices also increased crossing Rs 100 per litre for petrol in a number of cities in the past month. For diesel, too, the increase has been sharp from Rs 62.9 per litre in March to Rs  87.3 a litre in June.

On scanning the CPI by category, it is clear that transport prices have made the largest contribution to core inflation, rising by an average of 11.3 per cent in May on a year-on-year basis, reversing the decline in crude prices in early 2020.

But this would be just the primary effect. The secondary effect is more damaging as it percolates into prices of other goods too by way of transport, logistics and freight costs. As such, a part of the inflation that is being witnessed in milk, vegetables, oil can be attributed to the transmission of high freight costs..

To be sure, cuts in fuel taxes apparently are not planned even though RBI has repeatedly urged the government to lower excise duties. "The Centre has to cut taxes and cannot allow prices to go up further. The phenomenal rise in excise collections last year was due to higher duties as consumption was lower. For example, in FY21 consumption of petrol was around 3,900 crore litres of petrol and 8,600 crore litres of diesel. The combined consumption is around 12,500 crore litres and hence a Rs 1 reduction in taxes will mean just Rs 12,500 crore of outflow. This can be a big compromise," according to Madan Sabnavis, chief economist, Care Ratings.

While there is a fiscal cost for sure, he added, allowing inflation to go unchecked is a problem as it has also distorted the bond market with the MPC (monetary policy committee) firm on managing the yield curve.

Experience from the first wave suggests that lockdownrelated inflationary pressures are typically sticky. Currently, there is no evidence of a demand-pull pressure. The output gap is deeply negative, unemployment is high and wage growth is weak.

Economists believe even if commodity prices top out soon, price pressures are likely to build up further - not from a demand push, but due to a need for companies to compensate for the lost profit margin. "A likely recovery in demand would create room for the corporate sector to compensate for the margin compression experienced over what has been nearly a year, resulting in sticky CPI levels," added Bajoria.

According to Nomura economist Sonal Varma, "Even as the Governor seems to suggest that high inflation is a temporary phenomenon, we are more concerned. Coupled with rising supply-side (higher input costs) and demand-side (reopening) pressures, we now expect CPI inflation to average 6.1% y-o-y in 2022 and headline inflation to inch up higher to 6.5 per cent in June. In our view, looking through inflation for too long will risk even higher inflation in the medium-term."

The next couple of CPI readings will be important for establishing the extent to which the flare-up in May is reversed. The keenlywatched June CPI numbers are expected to be announced on Monday.