The great inflation escape

India, an economy infamous for high and persistent inflation, is currently coming to terms with the opposite phenomenon — inflation over the past year has not just fallen, but fallen more than expected. Inflation forecast errors have become one-sided.

Moreover, inflation components continue to confound, with persistent divergence between food and core prices. (Core inflation is defined as headline inflation minus food and fuel.) In the latest reading, food inflation is at -0.1 per cent and core inflation at 6.1 per cent, with a mysterious 6 percentage point gap between them. Headline inflation at 2.6 per cent is well under the 4 per cent target.

The big question doing the rounds is: Will headline move towards core or will core move towards headline? The two possibilities have diametrically opposite implications for monetary policy (rate hikes versus rate cuts).

Inflation in India can be divided into two clear phases. The pre-2013 period was characterised by rising food inflation and loose monetary policy (characterised by negative real rates). Inflation expectations became unanchored. Core inflation was elevated as transitory shocks became generalised more easily. And all of this manifested in core inflation converging rapidly towards headline.

The post–2013 period is characterised by the opposite —falling food prices and tight monetary policy. A combination of low global commodity prices and good harvests pushed food inflation down. As the Reserve Bank of India (RBI) embarked on inflation targeting, it consciously kept real rates in positive terrain.

As a result, inflation expectations became more firmly anchored. Transitory shocks began to fade more quickly. All of this has resulted in headline converging towards core, a sign that the country was perhaps moving a notch up on the macro stability radar.  

But if this is indeed the case, three questions become relevant: Why hasn’t headline been converging to core over the last year, as the post-2013 period suggests? Despite inflation expectations being better anchored since 2013, why is core inflation rising? Will headline inflation eventually go up all the way to 6.1 per cent (where core currently stands)?  

Here are three probable explanations.

We believe there has been a slew of price shocks over the past year that has distorted relative prices (of both food and core) and hindered convergence.

Food inflation has been falling sharply since early 2018. We believe there are both structural and cyclical factors for this. As demand in rural India gently recovers, partly led by the new direct cash transfer schemes announced by the government, the cyclical pressures could reverse. We forecast food inflation to rise from -0.1 per cent now to 3.5 per cent by March 2020, though still lower than the 6 per cent long-term average.  

Core inflation is not in equilibrium. It is in flux, grappling with a multitude of shocks, which we believe could ease off over the next year.

The education and health components of core inflation have spiked since October 2018. We find econometric evidence that the education inflation data in India is prone to idiosyncratic shocks which tend to dissipate. On the other hand, shocks in health can be both short-lived and long lasting. If the rise is due to a one-off jump in the index, for instance because responsibility for data collection has shifted from the post office to a new agency (the National Sample Survey Office NSSO), since September 2018, the consequent rise in inflation will show up for a year and fade away thereafter.

Lower oil prices, a more stable rupee and a high base could also help lower core inflation. Finally, if higher GST rates pushed the core index higher, this is likely to show up in the inflation print for a year, and normalise thereafter. All said, we believe core inflation could fall by a full percentage point a year down the line.

Once core inflation stabilises in the 4.5-5 per cent range, and food inflation begins to rise gently from the current very low levels, we expect headline inflation to converge gradually towards core, resting sustainably at the 4 per cent target one year from now. A huge win for a country that was earlier characterised by runaway prices.

Until then, however, headline inflation could remain under 4 per cent. We expect a 25bp repo rate cut in the April meeting, followed by another 25bp rate cut in June, taking the policy repo rate to 5.75 per cent by mid-year. Even with this, real rates will remain positive, in our view, anchoring inflation expectations further and strengthening the process by which headline inflation converges to core. 

One word of caution: We would hope that the Reserve Bank preserves these gains, and not cut rates by too much, too soon.

The writer is chief India economist, HSBC Securities and Capital Markets (India)