Inflation surprise

Latest reading has increased uncertainty

The inflation rate based on the Consumer Price Index (CPI) for January, which rose to a three-month high of 6.52 per cent, surprised most analysts by once again going above the upper end of the Reserve Bank of India’s (RBI’s) tolerance band. The rate was driven largely by food prices, particularly those of cereals, which went up by 16.1 per cent year on year. On a month-on-month basis, cereal prices were up by 2.6 per cent. Cereals and products have a weighting of 9.67 per cent in the combined CPI basket. While core inflation also inched up a bit and remains sticky above the 6 per cent mark, the level of increase in cereal prices is what has surprised economists. Besides, there seems to be some divergence in the understanding of the data. Nomura, for instance, in a note said: “Using official data, we find there is a wide divergence between the headline cereal index (top-down) and its subcomponents (bottom-up).” It further noted while the official methodology was more complex, both estimates so far had moved in sync.

Aside from the difference in understanding the data, which may get cleared over time, the January inflation number has put the RBI’s forecast for the current quarter at risk. The central bank had revised the inflation forecast lower by 20 basis points to 5.7 per cent for the January-March quarter last week. Therefore, the big question now is: What does this upside surprise mean for monetary policy? To be fair, the Monetary Policy Committee (MPC) in its meeting last week increased the policy repo rate by 25 basis points — taking it to a four-year high of 6.5 per cent — and kept the option of further rate hikes open. The committee did not signal that it would keep the policy rate on hold at the present level as many market participants were expecting. The central bank also projected an average inflation rate of 5.3 per cent for 2023-24. It remains to be seen if this would also face an upside risk. Notably, a number of market economists expect inflation in the next fiscal year to be lower than the RBI’s projection.
 

Clearly, if inflation outcomes continue to surprise on the upside, monetary policy would need to be tightened further to contain the momentum. The MPC will have more data before its April meeting and action is likely to depend on two important factors. First, to what extent will this upside surprise affect the expected inflation outcomes in 2023-24? If food prices soften with the arrival of the rabi crop, the MPC may want to look through the January and, possibly, February inflation numbers. However, if the pressure continues, the committee will have to respond. The second factor influencing the rate decision would be the required level of the real policy rate. Though the central bank may not explicitly talk about it, the rate may be higher than previously estimated. While the RBI has expressed concern over higher and sticky core inflation, a sustained pickup in the headline rate, which is the nominal anchor for monetary policy, will make things more complicated. The higher headline rate in January has increased policy uncertainty. It has opened up the possibility of another rate hike in the April policy meeting.