Core inflation more persistent than food inflation, and that’s a concern

The August 2022 CPI inflation printed at 7 percent, marginally higher than the consensus expectation of 6.9 percent (slightly up from 6.71 percent in July). The bounce was largely due to the food basket, primarily cereals at 9.6 percent YoY (average rice prices have risen 5.4 percent during mid-March to end-August 2022, wheat 12.2 percent). Vegetables prices were up 13.2 percent YoY although base effects of deflation in August 2021 were much more pronounced (compared to cereals). Cereals and vegetables have a combined weight of almost 16 percent in the CPI Index.

The core (non-fuel and food) inflation print was 6.1 percent (up slightly from the 6 percent for July). This has fallen from the average 6.4 percent over October ’21-June ’22, having peaked at 7.2 percent in April ’22. This measure is of bigger concern since core inflation is more persistent than food inflation. Core inflation also continues to remain quite broad based, with 59 percent of items in the core basket still above 6 percent. Central banks typically worry more about core inflation than headline, although this view now seems to have been abandoned in developed economies (DMs) given the frightening headline inflation levels.

On the global front, the outlook for metals, (non-gas) energy and agri commodities has ‘improved’, with prices now down from their peaks post the Ukraine war. For instance, the GSCI metals index is down 34 percent from the peak around mid-March to early September. The food index is down 23 percent from the peak in mid-May to end-August.

China’s economy is a key factor in these forecasts, with analysts now increasingly of the view that even the current GDP growth forecast of 3 percent might be difficult to meet, given the headwinds from the expanding COVID-19 lockdowns, and real estate woes. This, combined with rising risks of a global growth slowdown, including recession in many DMs, will likely further moderate commodities prices.

How will inflation in India look going forward? The RBI, in its early August policy, forecast 7.1 percent in Q2 FY23, 6.4 percent in Q3, 5.8 percent in Q4, and 5 percent in Q1 of FY24. The average FY23 inflation was maintained at 6.7 percent, with risks being broadly balanced. Note that CPI inflation will have breached the upper 6 percent band of the target range for three consecutive quarters (Q4 FY22 to Q2 FY23).

A key driver of core inflation will be the ability of corporates to pass on the accumulated higher cost of inputs to end consumers. Anecdotal and relatively dated (Q1 FY23) trends suggests that aggregate demand is still strong enough to permit a gradual pass through to end consumer goods prices to recoup profit margins.

In processing this information, the monetary policy committee (MPC) will have to balance multiple considerations, some of which will have opposing effects on inflation. Rather than focus exclusively on inflation, the MPC will take a broader view of the macroeconomic and financial markets outlook. This is in consonance with the RBI’s monetary policy response function operating in an open economy ‘Impossible Trinity’ framework, factoring in the effects of global policy spillovers via financial, commodities, and trade (and growth) channels.

First, the August US CPI inflation print on September 13 at 8.3 percent YoY was higher than expected (although lower than July’s 8.5 percent). Core inflation was also higher. Month on month (MoM) momentum remained strong. This has led to markets now pricing a 100 basis points (bps) hike at the September 21 Federal Reserve FOMC meeting (from the current 2.5 percent at the upper band), up from the earlier expected 75 bps, as well as higher than the earlier expected 4 percent terminal rate for this cycle.

This will inevitably stress emerging markets’ exchange rates, including the Rupee. The RBI’s own research indicates that a 5 percent depreciation of the Rupee (INR) leads to a 20 bps rise in the headline CPI. Hence, in addition to direct interventions in the currency spot markets, the RBI will have to calibrate its rate actions with currency stability as one of its objectives.

Adding to this discussion, the Finance Minister’s recent comments that inflation management is not just a monetary policy response, but requires supplementary fiscal measures, also suggest a view that aggressive policy rate hikes might not be warranted, so as not to adversely affect growth.

We expect the MPC at the end September review to further hike the repo rate by another 35-50 bps (from the present 5.4 percent) to 5.75-5.9 percent, depending on the RBI’s internal surveys of household inflation expectations, manufacturing companies capacity utilisation, business confidence, etc.

At what point might the MPC be expected to pause? Based on the RBI analytics, we had expected the terminal rate around 6 percent, but this might need to be increased if India’s financial markets conditions ease significantly with asset markets becoming bullish, offsetting the impact of monetary policy tightening.