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Dharmakirti Joshi: Will the happy tidings on inflation last?

RBI's target of eight per cent CPI inflation by January 2015 looks achievable but forecasting the inflation trajectory is still risky business

Dharmakirti Joshi 

Dharmakirti Joshi
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After a long time, inflation trumped most forecasts in the first two months of 2014. Consumer price index (CPI)-based inflation printed 8.1 per cent in February 2014 and the drop was faster than what market participants as well as policymakers had expected. Wholesale price index (WPI)-based inflation, too, was below five per cent in the same month, though it is no longer the Reserve Bank of India's (RBI) preferred inflation gauge.

Is this a flash in the pan? Or, will this trend endure in 2014-15 and, if so, what does it mean for the upcoming monetary policy?

I do expect CPI inflation to remain soft in 2014-15 and the odds are that it could end up lower than our current forecast of eight per cent. The RBI's target of eight per cent CPI inflation by January 2015, therefore, looks eminently feasible.

These developments suggest that interest rates can be kept on hold in the upcoming policy. I believe that it would be premature to cut interest rates until inflation is firmly on a sustainable downward trajectory.

Inflation could deliver a positive surprise in 2014-15…

There are several reasons the positive trend in inflation seen in the first two months of this year could continue in the coming fiscal, the foremost among them being
  • Weak domestic demand, which will curb the upside to inflation: With the economy operating below potential, the absence of excess demand will limit the transmission of supply shocks, if any, into core inflation. Demand is at its weakest point in the last decade with private consumption growth at two per cent in Q3 of 2013-14 - even lower than during the peak of the global financial crisis. We expect gross domestic product (GDP) growth to pick up in 2014-15, but the pickup will be mild and essentially driven by a weak base of the last two years, normal monsoons (assumed) and global recovery. In the absence of durable drivers of growth, household discretionary consumption spending will remain subdued. Until people begin to see a sustainable lift in the economy and job opportunities, they are unlikely to open their purse strings and create conditions for demand-side pressure on inflation.

  • Fiscal restraint since 2012-13, which has meant the absence of policy-led demand boosters: In 2009-10 and 2010-11, inflation was fuelled by private consumption, which was literally on fiscal steroids, supplemented by implementation of the Pay Commission recommendations and the spike in rural wages. Consumption expenditure on durable goods grew faster during this period than in the heyday of near nine per cent GDP growth prior to the global crisis. A replay of this scenario is nowhere in sight since fiscal policy has turned restrictive. Monetary policy, too, has remained tight. The impact of calibrated interest rate hikes (of 75 basis points since September, 2013) will play out in 2014-15 and rein in demand.

  • Soft global commodity and crude prices: Crisil Research expects crude oil prices to come down to around $102 per barrel in 2014 from an average of $107 per barrel in the previous year due to an improvement in supply vis-à-vis demand for oil. Oil supply (from the US, Iran and Iraq) has improved but the demand for oil remains weak since it is losing share to other sources of energy such as gas. Similarly, prices of commodities such as steel and other metals, too, will remain subdued this year due to the weak growth prospects of China.

  • Domestic food inflation, which is hard to predict: Moreover, the nature of shocks to food prices has varied each year. Even with good monsoons, food inflation has shown a tendency to spike. Given the high base in 2013-14, food inflation should remain low and could even come down further with normal monsoons in 2014-15. Rural wages now growing at a slower pace will also keep a tab on food inflation - particularly in items sensitive to incomes such as proteins.

…but monetary easing would be premature
Inflation dynamics in India has been quite complicated, difficult to fathom and full of shock and awe moments. Core CPI inflation in the new index remains high even in an anaemic demand scenario. Last year, despite an exceptionally good monsoon, food inflation spiked to 14.5 per cent in November 2013, its highest level since January 2012 (data on new consumer inflation are available only since then).

And, inflation surprises have been predominantly on the negative side. A trip down memory lane shows that in the annual monetary policy statement of 2010-11, RBI expected WPI inflation at 5.5 per cent (accounting for the sharp slowdown in GDP growth the preceding year). But actual WPI inflation during the year turned out to be over 9.6 per cent (fiscal stimulus was largely to blame for this) catching both analysts and RBI completely wrong-footed. A similar situation played out over the subsequent two fiscals as well - actual inflation turned out to be far higher than anticipated.

To be fair, inflation forecasting is a difficult business. Noise that could emanate from idiosyncratic shocks to agriculture (food has over 50 per cent weight) and global developments (currency, oil) make it difficult to accurately forecast the inflation trajectory. This year may be no different. There are preliminary warnings of an El Nino threat this year - if it materialises and adversely impacts the monsoons, food inflation can spurt. Similarly, if the recent turbulence in Ukraine spins out of control, oil prices can rise. But given the uncertainty over their occurrence and the enhanced comfort on inflation on other fronts, keeping interest rates on hold may be a prudent option for now.

Next January's eight-per cent-inflation target is certainly within reach. But the subsequent target - six per cent consumer inflation by January 2016 - will be difficult to achieve in the business-as-usual scenario. For that, food inflation will need to be fixed. The sooner we do that, the less costly monetary intervention will be to keep overall inflation under check. And that will also enable growth (below five per cent) and inflation (above eight per cent) to trade places - a dream outcome at this juncture.

The writer is chief economist, CRISIL

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First Published: Mon, March 31 2014. 21:45 IST