Climate of uncertainty

Take the current year, for example. A debilitating heatwave in March played havoc with the wheat crop. Despite a ban in exports, wheat prices have risen 19 per cent. And then came the patchy monsoon rains. Even though the season ended with rains that were 6 per cent above normal for the country as a whole, there were large regional and inter-temporal variations, especially in eastern India. Farmers tried to adapt, scrambling to sow as much as they possibly could, till late in the season. And it didn’t end there.

A delayed withdrawal of monsoon and uncharacteristically heavy rains in October are threatening to damage crops ahead of the harvest season. Vegetable prices have begun to rise and early estimates suggest that rice production could be 6 per cent below last year. All of this could stoke inflation expectations at a time when India’s inflation is well above the central bank’s target range, which is already grappling with shocks such as high and volatile oil prices.

And it’s not just about 2022. We find that decade-old rainfall trends are changing. Monsoon rains have become more volatile, deviating much more from normal than before, even as the number of episodes of unseasonal rains has risen.

In our experience, reservoir levels matter much more than rains for India’s food production and inflation, as reservoirs not only capture contemporaneous rains, but also store water from previous rain episodes. We find that reservoir patterns are changing too. A study reveals that compared to the last 10 years, we now get much lower reservoir water levels in July, and far higher levels in August. This matters because, traditionally, the bulk of sowing happens in July. But with insufficient moisture, sowing patterns have become far more volatile, creating inflationary pressures for food crops, even if temporarily.

We also find that long-held seasonality patterns in food prices are changing. Looking at the last decade, food prices used to rise gently each month between April and October every year. Repeating the study for only the last three years suggests that the rise in food prices in the April to October period is not as uniform as before. Rather it is bunched up as sharp increases across fewer months, making food price changes more volatile. This new trend is most pronounced for cereal prices.

Similarly, in the past vegetable prices used to fall in the December to February period. This was popularly known as the winter disinflation, with an implicit message to the central bank not to get carried away by the rise in vegetable prices over the summer months; rather to look through it and wait for the winter disinflation in order to get a clearer sense of where food inflation really is.

Now vegetable prices, too, are displaying changing seasonality patterns. The disinflation that was spread out over the December to February months now starts later and is concentrated in January and February. It’s no surprise that vegetable prices remain the most volatile component of the food basket.

And it’s not just food. Fuel inflation is impacted too. With temperatures rising and extreme weather events becoming more frequent, the demand for energy is also becoming more volatile.

To assess the changing demand for energy due to climate change, we model oil demand with the usual drivers like GDP growth, the ratio of manufacturing to services, and domestic oil prices. Our regression is economically and statistically significant. But what is most interesting for us is the non-economic drivers of energy demand, which we haven’t captured in our model, but can still get a handle on via the residual term. The residual term in our regression ends up capturing the other drivers of energy demand, for instance, those related to climate change. We extract the residual series and find that it has become far more volatile than before.

It is worth clarifying here that climate change can impact energy demand in several ways. In the first instance, episodes like a heatwave in March, or a colder-than-normal winter, raise demand for energy. Second, as the world transitions to renewables, there is likely to be a transition period during which fossil fuel-derived power is dis-incentivised before renewables reach their full potential. This period could be marked by volatile energy prices.

And so far, we are focusing on just a few aspects of climate change. There are likely many other changes underway simultaneously, impacting incomes, production and prices. Together, food and fuel make up 55 per cent of India’s CPI basket. With such a large weight of food and fuel, inflation in India has always been susceptible to supply shocks. And now weather-related surprises are on the rise, making India’s inflation patterns even harder to predict than before. It is therefore no surprise that inflation forecasting errors are on the rise.

This, then, raises the challenge for the central bank. With inflation volatility rising, it will become more challenging over time to anchor inflation expectations at desired levels. In some situations, this may require larger rate hikes in order to remain close to the inflation target, which, in turn, would slow GDP growth. The RBI may have to experiment with new techniques. For instance, raising rates earlier rather than later in the cycle, as a way of keeping inflation contained without too much cumulative tightening (a kind of early mover advantage).

And we’re only just getting started. Climate change is likely to impact other aspects of the economy too. Volatile rains can hurt farm incomes, and climate change-led increases in energy demand can widen the trade deficit, by raising coal imports, for instance.

India may eventually need a coordinated institutional framework tying together the different parts of policymaking in order to navigate the increasing volatility triggered by climate change and energy transition.

The writer is chief India economist, HSBC