Is India Experiencing Genuine Inflation Outbreak?

There is a lot of confusion about how we should think about inflation, and about how and when the various measures of inflation matter. 

As consumers, we care about headline inflation because it affects our purchasing power. So, changes in all goods and service prices, including energy and food, matter to consumers. 

However, this does not mean that central banks should target and set policy based on headline inflation. Rather, central banks should target genuine broad-based inflation in the economy before it becomes entrenched. 

When consumers experience rapidly rising food and energy prices, they will likely demand faster wage growth from their employers. If businesses are enjoying strong demand for their goods/services and facing a tight labor market, they might have little choice but to agree to pay raises to sustain their business. Companies will then attempt to protect their profit margins by hiking their selling prices. Households may accept higher prices given their incomes are rising. 

This dynamic could cause inflation to become broad-based and entrenched. In this case, central banks should lift rates to slow the economy materially and cool off the labor market to end the wage-price spiral. This is currently the case in the US. 

If employees fail to negotiate hefty pay raises, odds are that inflation will not become broad-based. The more households spend on energy and food, the less income they will have to spend on other items, causing their discretionary spending to contract. In this case, there is no rush for central banks to tighten policy. If monetary authorities tighten materially, the economy will experience a major downtrend. 

In short, wage dynamics determine whether inflation becomes broad-based. Labor market conditions will ultimately dictate this outcome. To be technically correct, unit labor costs, not wages, are key to inflation dynamics. Unit labor cost = (wage per hour) / (productivity). Productivity is employee’s output per hour. 

If high energy and food prices lead employees to demand faster wage growth from their employers, and if they are granted wage increases above and beyond their productivity advances, inflation will become more broad-based and genuine. 

If consumers push back against higher prices, i.e., reduce their spending, corporate profits will plunge, and companies will freeze investment and lay off employees. Wages will slow and inflation will wane. 

Using this framework, the recent rise in India’s inflation does not appear to be genuine, i.e., the wage and unit labor cost increases are currently very muted. Going forward, as tens of millions of young people continue to join the workforce every year, the broader wage picture in India is unlikely to change much. Subdued wage pressures will help keep a tab on the general inflationary pressures in the economy. 

In line with very sluggish wage growth, household consumption is quite weak − as is evident in depressed domestic car and 2-wheeler sales. 

The main reason is that demand-driven price pressures are absent in the current cycle. The sole source of inflation is higher global commodity prices, which could be peaking on a rate of change basis. 

Broad money supply (M3) determines India’s consumer inflation trajectory. The decelerating broad money supply means the odds of a demand-driven surge in consumer price inflation is also quite low.  

In the foreseeable future, there is little indication that India’s broad money supply will accelerate by any meaningful measure. This is because the major sources of money creation – bank credit origination and the central bank and commercial banks’ purchases of non-bank securities – will remain rather muted. 

India’s food inflation fluctuates more with the “Minimum Support Price” (MSP). This is the price that the government pays to farmers for procuring various food grains every year. Unless authorities announce a much higher MSP for the current year, both food inflation will likely stay under control. 

Finally, India is largely self-reliant when it comes to food. The buffer stock of the country’s food grains, currently at 74 million tons, far exceeds the estimated requirements. Short of any logistics debacle therefore, it’s hard to imagine that food prices could soar sustainably. 

On the whole, headline and core CPI in India will likely rise from the current levels of around 6.5%; but will not go past 8% on a sustainable basis. Our model for core CPI, based on the economic variables, points to a rather benign outlook (Chart 2).

All in all, the commodity-led nature of inflation in India also makes monetary policy a less effective tool to control it in this cycle. In fact, considerable monetary tightening will be a policy error as it could nip the already weak domestic demand in the bud. As such, it will be difficult for the RBI to continue to tighten monetary policy without causing a significant bear market in Indian stocks.  

Nevertheless, the RBI (Reserve Bank Of India) targets headline inflation, and it will likely hike interest rates further to control inflation expectations and appear credible. The US Federal Reserve continuing raising rates will also be a consideration for the RBI’s monetary policy decisions. 

Consequently, Indian share prices will drop further. India equity valuations are expensive, and rising interest rates will compress multiples. In addition, the economy will slow as borrowing costs rise. This is negative for corporate profits. 

Lastly, the Fed and US equity market remain on a collision course in the fog of inflation. Volatility on Wall Street will also dampen Indian share prices.

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