Fixed Income Economics Series

Thousands Gather for Kumbh as India Fights Covid Surge
April 12, 2021
India Inflation – At the crossroads of uncertainty

India’s Consumer Price Index (CPI) inflation averaged 6.2% y/y in FY21, with H1 at 6.7% and H2 at 5.6%. At its 07thApril meeting, RBI’s Monetary Policy Committee (MPC) decided to continue with the accommodative stance as long as necessary to sustain growth on a durable basis, while noting demand-side pull on inflation remains moderate. During FY21, the MPC often observed inflation outlook was uncertain and thatinflationary pressures were primarily supply shocks which would either dissipate or require proactive supply management strategies. Accordingly, it looked through phases of higher inflation (apart from the early period of imputed CPI data) and judged continued policy support was crucial for growth recovery. Could inflation throw new challengesin FY22?We endeavour to decipher this through various frameworks which identify the underlyingtrend in inflationary pressures andthroughfactors which could drive these.However, given the uncertainties which prevail, forecasts could have a higher margin of error than usual and have to carefully interpreted.

The current inflationlandscape through our frameworks

First, FY22 will begin with a period of high base effect. During Apr20-Oct20, CPI ranged between 6.2% and 7.6% and the cumulative monthly momentum was 6.4% vs. 4.7% during the same period in 2019. This will aid lower y/y readings ahead. We will also be in a period of missing component level y/y data till May, given higher-level numbers were imputed during Mar20-May20 as data collection was hit due to Covid. Thus, it will be more important to track the sequential momentum in components, adjusted for seasonality.

Second, we look at the diffusion-total number and weights of components within various categories showing positive m/m momentum –to gauge how extensive price pressures are. We find:

  • At the headline level, diffusion has directionally fallen since Oct20 but this masks the trend in various sub-categories. The fall was mainly led by disinflation in food items.
  • Price pressures in core CPI have been rising, barring the most recent fall, driven by both goodsand services.
  • Scale of price pressure in certain categories,e.g. fuel & light, has actually eased of late but the high value of positive readings concentrated in a few sub-components has kept their overall contribution high. In such cases, it is to be seen whether this concentrated momentum eases, how other sub-component prices evolve, etc.

 

Figure 1: CPI diffusion indicators in the last six months

Total number of components in category Weight in CPI basket (%) Number of components – flat or positive m/m (% share in total of category) Weight – flat or positive m/m (% share in total of category)
Oct-20 Nov-20 Dec-20 Jan-21 Feb-21 Mar-21 Oct-20 Nov-20 Dec-20 Jan-21 Feb-21 Mar-21
CPI headline 299 100.0 75 68 67 73 66 68 76 76 63 75 75 70
   Food and beverages 127 45.9 72 55 52 54 46 53 71 60 54 56 57 58
        Cereals & products 20 9.7 50 40 45 45 55 20 19 18 20 20 49 7
        Vegetables 21 6.0 81 14 14 29 29 33 86 29 8 19 21 18
   Pan, tobacco and intoxicants 16 2.4 81 75 88 94 69 56 78 74 94 85 76 36
   Clothing & footwear 27 6.5 85 96 85 100 81 89 91 99 90 100 92 96
   Fuel & light 11 6.8 73 82 91 100 82 73 96 76 100 100 66 63
   Miscellaneous 114 28.3 75 74 75 82 81 81 68 88 80 83 93 78
        Household goods & services 48 3.8 81 77 75 77 83 79 70 90 87 56 94 61
        Recreation & amusement 16 1.7 69 56 81 69 56 81 85 78 99 99 91 99
        Personal care & effects 16 3.9 75 75 75 88 81 75 69 59 71 100 72 60
        Transport & communication 22 8.6 68 68 77 100 86 82 32 88 95 100 97 68
CPI ex-food & beverages, fuel & light 161 47.3 78 78 78 86 80 80 78 91 66 89 94 82
CPI services 38 23.3 63 63 63 82 84 76 83 95 40 84 98 84
CPI goods ex-food & beverages 135 30.8 81 82 83 89 79 79 80 85 94 97 85 77

Source: CEIC, IDFC MF Research

Third, splitting the CPI inflation into goods and services baskets, we see:

  • Headline CPI follows goods inflationclosely given its77% weight in the overall basket. So, if we exclude food and beverages from goods, we see prices have been rising steadily.
  • In services, even after we exclude housing and mobile telephone charges (which rose 15-16% consistently in 2020), we see core services prices have also been rising for a while (reinforces higher diffusion in services discussed above), but its weight in the CPI basket is only 11.4%. For it to meaningfully impact headline CPI, magnitude of readings has to rise quite sharply, alongsidehigher diffusion. However, recent RBI research suggests services prices being the relatively sticky component in the CPI basket can spill over to goods prices and result in generalised price pressures.
  • Within services, momentum in personal care and recreation services has been strong for quite some time while that in household serviceshas picked up only more recently.

 

Figure 2: CPI core goodsbasket                                            Figure 3: CPI core services basket

Source: CEIC, IDFC MF Research. Note: Data not availble for Mar20-May20.   Source: CEIC, IDFC MF Research. Note: Data not availble for Mar20-May20.

 

Fourth, to understand core price pressures better, we construct trimmed means of the headline, core goods and services CPI categories. For e.g., the 10% Trimmed Mean (TM) is based on 80% of the category-basket as it excludes 10% each of the highest and lowest y/y readings. It is thus an unconventional measure of core inflation defined by exclusion ofdynamic components based on their readings each month. It does not pre-define static components for exclusion from the headline as in (for e.g.)CPI ex-food & beverages fuel & light.

Key inferences are:

  • For goods excluding food and beverages, the 10% TM is well below the main index, suggesting concentration of net price pressure in just the top 10% of items, which pushed the TM down. However, the gap has fallen since Sep20.
  • For services, the 10% TM was above the main index till Nov20 but fell sharply in December and has stayedbelow the main index. This suggests sudden and sharp price pressures concentrated in the top 10% of service-components which pushed the TM down only recently. Thus services price pressures seem to be manifesting but sharp rises seem to be concentrated and not broad-based for now, even more compared to core-goods.
  • In terms of categories, for core goods, higher price pressures seem to be mainly concentrated in pan, tobacco and intoxicants, gold & silver, petrol & diesel. For services, this seems to be mainly in transport.

 

Figure 4: 10% TM for goods ex-food and beverages                    Figure 5: 10% TM for services

Source: CEIC, IDFC MF Research. Note: Data not availble for Mar20-May20.   Source: CEIC, IDFC MF Research. Note: Data not availble for Mar20-May20.

Thus, the above frameworks suggest prices pressures (even ex-food and beverages) have been rising. This is visible in the total number & weights of items showing positive price momentum and various compiled sub-categories of core goods and services. However, in terms of magnitude of readings, our trimmed means suggest these higher price pressures are still quite concentrated, particularly for services.

Factors that could shape the inflation trajectory

Variousfactors which could define the path of inflation are:

  1. Input cost pressures from higher commodity prices, of which crude oil price is the most important, could be passed on to consumers as manufacturers’ profit margins get squeezed.However, most of thisprice rise seemsto be over and incrementally it could soften if demand weakens with a rise in Covid infections.
  2. Some sectors skipped price hikes in 2020 and are due in 2021, but further delay or only a partial roll out of planned price hikesis possible if demand gets weaker,input prices ease or price elasticity of demand moves higher.
  3. Domestic supply constraintsfromrising infectionsand policy response is possible but the scale is likely to be much lower. Global supply disruptions from dearth ofshipping containers in major trade routes and manpower shortage are ongoing.
  4. One-year-ahead inflation expectation of households has risen since Mar20 but could be guided by food and fuel prices.
  5. Change in INR/USD. RBI estimates 5% INR depreciation from its baseline to increase CPI by 20bps and vice versa.
  6. Services sectorrecovery has been lagging manufacturing, but price pressures have been emerging. However, recovery could be further delayed and recent concentrated price pressures may find it difficult to broaden or even sustain.
  7. A normal monsoon season, healthy reservoir levels, good crop output during the upcoming Kharif and the following Rabi sowing seasons could keep food prices soft.
  8. Effective supply management strategies by the government, for food and other goods, could alleviate price pressures.
  9. Cuts in tax on fuel, coordinated by the central and state governments, could help easetransport costs and prices of other goods and services through second round effects.

 

Further, demand and supply will be defined by the fact that households and companies are better prepared this time, their behavior may not be as fear-driven as before and vaccinations are progressing with the governmentexploring more options.

What makes the impact of these factors uncertain?

Whether, when and howthe above factors play out have become uncertain.

  • The biggest uncertainty is the path of the pandemic, which is currently in the form of a tall second wave. Any virus mutations, change in nature and pattern of infections, etc. would matter.
  • Not having enough vaccines, at least in the short run, to keep pace withdaily doses administered is an issue.
  • For now, the base case seems to be of government policy response to be not as stringent and widespread as in 2020. While this is the most reasonable assumption, it is to be seen if and how this changes with the path of the virus, testing, pressure on states’ health infrastructure,measures taken by other countries, etc.

 

All this makes incremental FY22 growth downgrades possible but the overall economic impact of the second wave would most likely still be quite lower than that of the first wave.

Inflation forecasts with a higher margin of error

Immediate CPI readings would likely be driven by the ongoing disinflation in vegetables & cereals and base effects. The landscape of inflation, we explored through various frameworks, gives us a clear understanding of other price pressures.However, thesecould change faster than usual inthe currentbackdrop andforecasting CPI beyond a few monthsis more aboutone’s view about the above factors.Itis likely less data-intensive as typical seasonalities, price-pressure mix and momentum within various sub-components get challenged.The RBI in its recent Monetary Policy Report noted considerable variation in price build-up across subgroups of core categories, post lockdown vs. its longer term average.We had previously highlighted some of the noise and suddenly changing drivers within core data and thus the need for careful assessment (click here). All this makes forecasting more nuanced, view-based and implicitly widens the confidence-interval and the margin of error in estimates.

Similarly, India’s medium term inflation dynamicsalso will depend on various aspects like company-fatalities (and how many of them return) due to Covid, within MSMEs and the informal sector, which will impactproduction, labour market dynamics (actual and expected employment, wage growth and mix) and household balance sheet strength which was not solid even pre-Covid (household debt to GDP increased sharply to 37.1% in Q2 FY21 from 35.4% in Q1 FY21 as per the RBI). Thus, the K-shaped recovery evidenced even from recent quarterly results of listed companies, the economic scarring and the impact on the wage-cycle it causes will have consequences for medium-term inflation through first and second round effects (or its absence). Unfortunately, we don’t have real-time data to measure this and the impact from Covid is not yet over. Further, whenever recovery gets stronger, a partial but strong shift in consumption from goods to services is possible. This, alongside the price setting cycle for goods and services, will impact overall inflation.

For FY22, consensus on average CPI inflation has been in the 4.5-5.0% range. More recently, it has inched down from the higher end of this band and thus below the RBI’s latest forecast of 5%. Most of these estimates do not assume any major episodes of supply-related food inflation spikes,which are nearly impossible to predict even in normal times, or a major price impact from Minimum Support Price (MSP) hikesbased on the experience in recent years.More importantly, any major incremental changes in monetary and fiscal policies from that broadly envisaged currently, if India’s cyclical recovery gets hit materially, is currently not factoredin as it is still very early days.

Summary

Our inflation frameworks suggest the current landscape is one of rising price pressures from goods and, more recently, from services but these still seem quite concentrated, particularly for services. Various factors like input costs, price hikes, health of the services sector, INR/USD, crop output, government tax and supply management strategies, etc. could impact inflation but the current path of the pandemic and vaccinations make it highly uncertain, despite the economic hit from the second wave unlikely to be as big as in 2020. Thus,forecasting inflation based on the recent past, as price pressure patterns are changing fast and diverging from longer-term trends, could be more about views, less about data and consequently have a higher margin of error.We see a similar issue in deciphering India’s medium-term inflation dynamics too as real-time detailed data on labour markets and to gauge economic scarring are unavailable and the hit from Covid is not yet over. In the new normal, uncertainty is the only certainty.

 

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