Can CPI inflation stay within RBI’s tolerance band?

Food prices have pushed inflation higher but it is likely to retreat

Inflation and inflationary expectations seem to be ramping up, if one were to go by the latest round of data points. For instance, the Reserve Bank of India’s Survey of Households for June 2016 indicates mounting inflationary expectations. This may have been unduly influenced by the recent uptick in food prices. The latter has led CPI inflation to cross the upper tolerance level (4 per cent +/-2 per cent) set by the Centre for the period up to March 2021. Inflation hardened to 6.1 per cent in July 2016.

Not just that, WPI inflation — even as its relevance has faded in the current regime that targets CPI inflation — has recorded a relatively broad-based uptick in the current fiscal, after a prolonged sub-zero spell.

Food-led inflation

The increase in food inflation in recent months has been led by vegetables, pulses and sugar. This trend is likely to change, aided by a few factors. One, prices of some vegetables have already started to moderate in the ongoing month, and are likely to decline further after the upcoming harvest.

Two, the higher minimum support prices and bonuses offered by the Government have served well to enhance the attractiveness of cultivation of pulses.

The area sown under pulses stood at 13.6 million hectares as on August 19, 2016, a considerable 18 per cent higher than the final coverage of 11.5 million hectares achieved during the kharif season in 2015, which should cool the alarmingly high inflation for this key protein item.

That said, lagged sowing of sugarcane does not bode well for sugar production or for an imminent decline in prices.

Also, after three-quarters of the passage of the monsoon season, its outturn has been mixed. Surplus rain in July 2016 allowed for sowing to burgeon and reservoir storage to replenish rapidly. Subsequently, August 2016 has been characterised by sub-par precipitation in some areas and floods in others, the impact of which on standing crops is being assessed.

So, the magnitude and distribution of the September rains will be crucial. Still, based on the available trends, kharif production in 2016 is likely to significantly outdo the 2015 harvest.

Improved supplies of several food items, combined with a favourable base effect, should dampen food inflation at the retail level in the coming months, counteracting the risk posed by firming global food prices.

With almost half of the CPI comprising food items, lower food inflation would soon ensure that retail inflation retreats within the tolerance band of 2-6 per cent.

Delayed allowances

Another factor that can influence the CPI’s upward trajectory is the impact of the Pay Commission.

On this front, the roll-out of revised allowances, based on the Seventh Central Pay Commission’s recommendations, has been deferred as of now.

This would temporarily benefit the CPI trajectory, as the rise in house rent allowance would eventually enhance the housing index.

Nevertheless, the impending revision of pay and pensions for Central Government employees would boost domestic demand in the ongoing fiscal, simultaneously posing as an engine of growth and an inflation risk.

This is chiefly so for services such as education and health, which make up an estimated one-quarter of the CPI basket, and whose domestic supply tends to be fairly sticky and difficult to supplement through imports.

Additionally, a subtle shift in demand for food with greater nutritional content cannot be ruled out, which could exacerbate future price spikes, related to the periodic emergence of short-term demand-supply mismatches.

Narrowing gap

Inflation for manufactured goods is likely to remain contained in the current year, with the impact of rising demand likely to be buffered by the prevailing moderate capacity utilisation levels. With a limited weight of food articles in the WPI, wholesale inflation is expected to rise in the coming months, led by higher prices of imported commodities as well as domestic inputs such as cotton. The gap between WPI inflation and CPI inflation would narrow considerably in H2 FY2017.

There is a low likelihood that the CPI inflation would exceed the interim target of 5 per cent by a wide margin. So, additional monetary easing of 25 bps during 2016 may be expected.

The chief sources of uncertainty related to the inflation trajectory during FY2018 include the final structure of the GST rates, the timing and extent of pay revision by the State Governments, the trends in domestic food output and the global commodity prices.

The timeline set for the transition towards the inflation target of 4 per cent would also influence the space perceived by the Monetary Policy Committee to reduce the repo rate in 2017, even as the quantum is likely to be limited.

The writer is senior economist, ICRA Limited

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