Food price rise: How RBI can still find room to ease
In December, CPI inflation soared to 7.4%, its highest print in over five years. This has come at a time when economic growth has slowed to 4.5% year-on-year (y-o-y), well below India’s potential growth rate of c.6.5%. With such weak growth, where has all this inflationary pressure come from? How long will it last? And, can it unsettle the monetary easing cart?
A quick look suggests that food inflation has risen from 3% y-o-y in August to 12.2% in December, explaining much of the rise in headline. We divide the rise in food inflation into two parts: The spike following the vegetable price shock, and the rise in food inflation pre-dating the vegetable price shock.
The sharp rise in the price of vegetables since August seems to have driven much of the spike in inflation. This was not a big surprise. Insufficient rain at the start of the monsoon season, followed by floods later on, played havoc with vegetable crops.
However, this is not where it ends. A careful look reveals that it is not just vegetable prices that are rising—in fact, the rise in food inflation is widespread across several categories. Moreover, food prices had started to tick up even before the vegetable price spike. This complicates the picture. Why is food inflation becoming generalised at a time when wage growth, and economic growth are sluggish?
The spillover from the vegetable shock
Vegetable prices have risen sharply since August. As mentioned above, this did not come as a big surprise given reports of flooding hampering vegetable crops.
However, the rise in inflation is not limited solely to vegetables, which account for 13% of the food basket. Inflation in 50% of the food basket, which is comprised of cereals, oil, vegetables, sugar, and spices, has been rising since August.
We are not overly concerned. We find econometric evidence that when inflation rises in an important constituent of the food basket, like vegetables, it spills over into other items in the food basket due to substitution effects.
In an Ordinary Least Squares (OLS) econometric framework, we regress non-vegetable food inflation on vegetable inflation (while controlling some of the other variables that impact food prices). We find that a spike in vegetable prices can spill over into non-vegetable inflation, with a lag of one month. Our results are statistically significant.
By the same argument, when a new vegetable crop arrives over January and February, the price of all these food items could decline. In fact, the price of vegetables tends to fall during winter months, leading to a fall in the overall food index.
As a consequence, this spike should not concern RBI too much.
Implications of a supply-side adjustment
However, one-third of the food basket—comprising milk, fruit, eggs, meat, fish, and pulses—has seen a rise in inflation that pre-dates the vegetable shock. What is going on there?
We find that trend inflation for each of these food items has fallen sharply over the past few years.
Over the last few quarters, actual inflation has fallen well below the (already low) trend for milk and fruits, and is, now, just about catching up. The rise in inflation can, therefore, be labelled normalisation.
However, it is a bit different for protein rich pulses, eggs, meat, and fish. For these items, actual inflation has overshot trend inflation. Here, we see signs that production is being cut. Given the sharp decline in food prices over the past few years, producers have either planned a production cut, as in the case for eggs, where production is likely to be down 25-30% this year, or had unplanned production cuts due to supply-side issues like untimely monsoon rain damaging pulse crops.
This supply-side, adjustment-driven food inflation could linger for longer, in our view. That being said, because the demand side is weak, we do not think inflation in these items will rise too sharply.
RBI could still find room to ease
All told, 50% of the food basket could see some disinflation when the new vegetable crop arrives over the winter months. Conversely, one-third of the basket could continue to see higher inflation while a supply-side adjustment is under way.
Meanwhile, the growth momentum remains weak and will likely keep a lid on core inflation. In the December reading, too, core inflation (headline, excluding food, fuel, petrol, diesel, and housing) actually fell to 3.5% versus 3.8% last month.
Putting food and core inflation together, we expect headline inflation to fall to the 4.5% area by mid-2020, moderating further towards the end of 2020 as a high base kicks in.
With growth well below potential, this is likely to open up space for easing again. We expect RBI to cut the policy repo rate by 25bps in June, taking the repo rate to 4.9%.
The author is Chief India economist, HSBC (Views are personal)
Excerpted from HSBC Global Research’s India: RBI Watch: Oi Food!, December 2, 2019