Inflation-brace for aftershocks

Inflation is here to stay. It is currently affecting different groups of people in different ways. But as price pressures spread, everyone will be similarly impacted, leaving weaker growth and sticky prices which will outlast the commodity price shock. We answer some pressing questions.  

Have the global price increases fed fully into domestic food inflation?

Not all the price pressures have been passed on yet. At least three channels will lead to higher food prices. One, wheat prices in India could rise further, led by rising Indian wheat exports, a lower domestic crop yield, and a possible demand-supply mismatch at public sector granaries. While stocks at public granaries soared in the past two years, they have fallen recently. If wheat prices rise this may spill over into rice, a close substitute. A lot hinges on the monsoon rains and fertiliser availability in the summer rice season.

Two, rising global edible oil prices, led by supply disruption and a recent export ban by Indonesia, could stoke food inflation. India is an importer of edible oils and edible oil inflation rose 19 per cent year-on-year (y-o-y) in March.

Three, rising input costs (e.g. the price of diesel, fertiliser and cattle feed) will push up the price of all food items. The agricultural input cost index was up 15 per cent y-o-y in March and the full impact will be felt when the current crop is harvested in a couple of months.
 

Is the pass-through from corporates to consumers complete?

Dividing wholesale price index, or WPI, inflation into input and output prices, we find that only 50 per cent of the input costs over the last six months have been passed on — generally, it’s about 80-90 per cent. For now, fear of weak demand may be preventing a full pass-through. But if input costs remain high, higher pass-through may be necessary and the growth drag will shift more from corporates to consumers.  

Another pass-through that is incomplete is fuel inflation. WPI fuel inflation is outpacing consumer price index, or CPI, fuel inflation by a large margin. This is due to the difference between primary and secondary energy costs. The primary energy cost of mineral oils and coal has soared and this is picked up in the WPI inflation index.

But secondary energy costs, particularly retail electricity prices, rise only when tariffs are increased. These costs make up a larger share of CPI inflation, keeping CPI fuel inflation relatively low for now. As electricity tariff adjustments are made over the next year, CPI fuel inflation will begin to rise. And this should keep India’s inflation high and sticky for longer.

Will goods or services drive inflation in 2022?

Goods producers have passed on more input cost increases than services producers. This is not surprising as goods demand recovered quickly after lockdowns ended, while services demand is still recovering.

While goods inflation will likely outpace services inflation to begin with, services inflation could begin to catch up. This also has growth implications. Pent-up services demand is a key driver of growth but once that runs its course and prices rise, services sector and gross domestic product growth could weaken.  

Why is rural inflation outpacing urban inflation?

Rural inflationary pressures are outpacing urban inflationary pressures, led by rising primary fuel costs. For example, the prices of kerosene used for lighting and bulk diesel for water pumps are not regulated and have risen sharply.

Urban Indians use more secondary energy like electricity, where prices rise only with a lag, as discussed earlier. Once electricity tariffs are raised, urban inflation may see a similar increase, narrowing the rural and urban inflation gap. This has implications for growth as the real purchasing power of urban Indians could begin to fall around the time the ongoing fillip from pent-up services demand will begin to fade.  

Which income group has borne most of the input price shock?

We assess the impact of CPI inflation on different income quartiles. Early in the pandemic (2020), the top 20 per cent income quartile faced lower inflation than the bottom 20 per cent. The top quartile is associated with large companies and the bottom quartile with small, informal firms.

Since early 2022, this phenomenon is being repeated. Again, small firms unable to withstand the sudden rise in input costs are closing and the supply disruption is pushing up prices. If input costs do not abate quickly, the growth drag from this group could spread.

Will inflation dip and growth soar when the commodity price shock abates?

There is a general belief that as soon as commodity prices begin to fall, inflation will dip and growth will pick up pace. We are not so sure and see three reasons why elevated CPI inflation could outlive the commodity price shock.

One, large firms have gained pricing power through the pandemic and may not lower prices quickly once commodity prices ease. Two, electricity tariffs are only raised with a lag of about a year; the losses faced by power distribution companies today will only be covered a year later. Three, higher agricultural input costs could impact food prices over the next year as the Kharif and Rabi season harvests progress.  

In addition, we see three related reasons why the impact of high commodity prices on growth will show up more clearly down the line. One, as services demand rises further, producers may start passing on more input cost increases to consumers, eroding purchasing power and growth. Two, as electricity tariffs are raised over the next 12 months, the urban cost of production and living could hurt growth. Three, if the informal sector demand weakens, its impact could be felt by formal sector producers down the line; after all, they produce for the entire economy.

Brace for aftershocks.

The writer is Chief India Economist, HSBC Securities and Capital Markets (India)