How much has core inflation really fallen?

Inflationary pressure softening: leeway to RBI for a rate cut

In May, the wholesale price index (WPI)-based inflation fell to 4.7 per cent from 4.9 per cent a month ago. While overall inflation is now within the Reserve Bank of India's threshold level of five per cent, it is crucial for the monetary policy making to correctly gauge the underlying demand pressures in the economy.

This is done by excluding the prices of commodities not directly influenced by domestic demand. For example, the prices of food and fuel items are swayed by fluctuations in supply, influenced by administrative price hikes, global prices, and value of the rupee. Measures of core inflation are often calculated by excluding such prices to measure demand momentum.

The frequently-used measure of core inflation in India is non-food manufacturing inflation, which fell below three per cent in April for the first time since January 2010. In May, it fell further, to 2.4 per cent.

Could a drop in non-food manufacturing inflation be exaggerating the extent of demand moderation?

In April 2012, CRISIL released an alternative measure of core inflation - CRISIL Core Inflation Indicator (CCII) - that, we believe, is a better indicator of underlying demand pressure on prices and more stable than non-food manufacturing inflation. In May, CCII was at four per cent, compared to non-food manufacturing at 2.4 per cent.

CCII is defined as manufacturing inflation excluding prices of base metals. It differs from non-food manufacturing inflation in two respects. First, it excludes base metals prices, which are determined by global demand-supply factors and tend to be highly volatile. Leaving these out makes the measure more stable as well. Second, unlike non-food manufacturing inflation, CCII includes prices of processed food, as these prices represent domestic demand strength, and not an influence of supply-side shock on primary food prices.

Although both indicators of core inflation have been declining in recent months, the wedge between these has widened. After July 2012, there has been a correction in global prices of metals. In May, prices of ferrous and non-ferrous metals together fell by 1.8 per cent compared to a year ago. In such a situation, non-food manufacturing inflation can exaggerate the extent of a decline in core inflation. A similar situation had risen in 2009, when non-food manufacturing inflation went into a negative zone due a severe fall in global metal prices. Subsequently, base metal prices rose sharply to 5.9 per cent in April 2010 from -1.8 per cent in July 2009.

The behaviour of CCII suggests the room for monetary policy easing is not as much as indicated by the drop in non-food manufacturing inflation. As and when demand pressures resurface, CCII could again move over five per cent, since the economy's supply potential or the trend growth has fallen. It is therefore, critical to keep monitoring the developments in CCII. Sustaining WPI-based inflation around five per cent would be monetary policy's biggest contribution to the cause of higher growth.