It would be a challenge to sustain food inflation below 8% even if inflation in protein-rich foods moderates further. Any supply-related shock, not just sub-normal monsoons, could push food inflation into double-digits. Monsoon itself is at risk this year due to signs of an El Nino and needs to be watched closely. Worsening of geopolitical tensions in Ukraine could also push oil prices higher during 2014 and create a supply-side shock for inflation in oils & fats. Higher oil prices in the past (FY12, FY13) have been seen to fuel inflation in this category.
With core CPI inflation still lingering around 8%, any surge in food inflation will make it difficult to sustain the overall CPI inflation within the target of 8% by January 2015 even if second round effects of the food price rise are very limited due to weak demand conditions. Monetary policy, therefore, cannot afford to be loose -- at least not until core CPI inflation adjusts downwards. Rates will therefore have to remain on hold for now.
Unless supply-side bottlenecks in agriculture are resolved, the downside to food inflation will continue to be limited, one-off and unsustainable. Simple calculations show that even in an optimistic scenario average food inflation is unlikely to fall below 8%.
Optimistic scenario (all of the following):
Monsoons are normal
Limited hike in minimum support prices (MSP's) of cereals and pulses
Protein (egg, fish, meat & milk) inflation trends down due to weak growth in incomes.
Supply-related shocks, if any, are small
Further, even if the scenario plays out for two consecutive years, it will be difficult to bring CPI inflation down towards 6% by January 2016. For this, non-food CPI inflation, comprising fuel, clothing, bedding & footwear, housing and services, will have to fall close to 4% -- a sharp decline from an average 7.9% for 2013-14 (April-February). Such a sharp decline in non-food CPI inflation would not be possible to achieve if the monetary policy is loose. Even momentum indicators, which should reflect the impact of past rate hikes on inflation, do not show signs of easing in non-food CPI inflation.
In the event of a significant shock to food prices in 2014 -- a scenario which, given past experience, cannot be ruled out - food inflation could rise once again to double-digits.
Base case scenario (any of the following):
Monsoons are sub-normal
Supply-related shocks materialise
Significant hike in MSP's of cereals & pulses
In this scenario, non-food CPI inflation will have to be brought down to 6% for overall CPI inflation to be capped at 8% by January 2015. Given the downward rigidity in core CPI inflation and high likelihood of supply shocks to food prices in India, monetary policy must remain on hold for now.
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