Riding the inflation wave

Watching India’s inflation trends these days gets us humming The Doors’ 1967 popular single, “Break on through to the other side”. And why not? Inflation in India has clearly changed sides. From 11 per cent in the FY09 to FY11 period, it has fallen to 4.5 per cent in FY17 and is likely to average 3.6 per cent in FY18. So promising is this that the Reserve Bank of India, in its June 7 policy meeting, slashed its full year inflation forecast by a whopping 140bps, the largest cut in recent memory. What’s going on here? And how long will it last?

We ran a series of theoretically rigorous yet simple regressions to figure out what really drives inflation. In particular, we modeled consumer prices, the output gap (a measure of the difference between the economy’s actual output and potential output), minimum support prices, or MSPs (government-set floors on agricultural produce prices, which often work as the ceiling), and rural wages. These are all interconnected and important in understanding the intricacies of inflation in India.

Our findings give us some powerful messages. First, we found that it is the same “cast of characters” impacting inflation, regardless of whether we are assessing periods of rising (eg. FY09-11) or falling (eg. FY14-17) inflation. Second, we find that inflation expectations, both backward and forward combined, explain about 75 per cent of the trends in actual inflation. Third, the remaining 25 per cent is explained by “other factors”, such as reservoir levels, policy discretion (for instance in the setting of MSPs), global commodity prices and the rupee.

Inflation expectations are a stubborn animal. Once they take hold, they feed off themselves, falling into a multi-year cycle. FY09-11 was a vicious cycle of inflation expectations in which higher inflation in the past triggered higher inflation in the future. On the other hand, FY14-17 was a virtuous cycle in which falling inflation each year triggered even lower inflation in the next.

In both cases, the persistence of the cycle was strengthened by institutional characteristics unique to India. Our analysis showed that the setting of both rural wages and MSPs leans heavily on inflation in the previous year. 

We also found that inflation expectations have now fallen into a virtuous cycle and are likely to stay there, comfortably anchoring India’s inflation rate at the 4 per cent target, unless some of the so-called “other factors” turn sour enough to yank them out.

But could those things turn sour? Growth, which has slowed sharply this year, could rebound, but updated growth numbers suggest that there has been weakness on the ground since mid-2016 that is likely to keep the output gap negative for longer. In fact, our estimates suggest that the output gap is likely to remain negative for much of 2018. This is likely to keep core inflation, which has already fallen to 4 per cent, in check.

There is always some risk of oil prices rising gradually over time, but a stronger rupee would offset some of the impact. In fact, we estimate that the 5 per cent appreciation in the rupee since the start of the year will shave off 25bps from the inflation rate over 2017. Reservoir levels, a key determinant of food prices (given they capture not only the impact of monsoon rains but also the carry-over moisture from the previous season), could be inadequate. But so far they are trending well above normal and rain forecasts for the next few months are promising. Finally, the housing allowance for public servants could have second-round inflationary effects, but our analysis suggests that as long as the output gap is negative, these are not likely to be major.

In fact, we think some of the “other factors” could even go right. While a lot has been said and feared about the goods and services tax (GST), it seems that the tax rates have been set such that, if over time tax cuts are passed on to final consumers and the input tax credit mechanism works smoothly, the GST could actually cause inflation to fall by 10-50bp. 

A part of the dramatic fall in food prices could be structural. States such as Maharashtra have liberalised trade in fresh foods in July 2016. Karnataka has emerged as a leader in digital food markets. Food prices in these states have fallen sharply recently and may not reverse in a hurry. At the same time, the government has become much more nimble in food distribution — importing, exporting, buying and selling food grains more efficiently. All said “other factors” do not seem to be a source of worry at this point. 

Of course there are always several risks in the horizon. If a wave of farm loan waivers spreads across the country, worsening India’s debt and deficit ratios, and is coupled with soaring MSP increases, the benign inflation trends could get disturbed. 

But until we actually see these risks taking hold, we believe the RBI has space to undertake some modest easing over the next few months and yet meet its 4 per cent target comfortably over the foreseeable future. The opportunity to continue cutting, and yet meet ambitious inflation targets in a country infamous for runaway inflation, is rare. But when a strong wave of benign inflation expectations hits you, there is only one thing you can do. Ride it.
 

The writer is Chief India Economist, HSBC Securities and Capital Markets (India)