July inflation print did not cause any celebrations. Why it should have

India’s consumer price index (CPI) inflation dropped to a 59-month low of 3.5 per cent year-on-year (y-o-y) in July. Yet, this did not lead to any celebrations. The reasoning, according to the consensus view, is that the drop in inflation is due to base effects and that risks related to food inflation are tilted to the upside. Therefore, monetary policy cannot let its guard down, especially as growth is strong and there is a need to lower credit growth and narrow the credit-deposit growth gap.

We would push back against this consensus view for the following reasons.

This is not just base effects: Base effects did play a role, but they were well known, so the downside surprise in the July CPI implies weaker-than-expected momentum. July saw a steep upward revision in mobile tariffs; yet the sequential momentum for core inflation rose at the same pace as in June, meaning that inflation in most other core categories remained benign.

Food inflation is not a big risk: Food prices are volatile and hard to predict, but high frequency data shows that prices are cooling or will cool soon. Nearly 50 per cent of food inflation so far in 2024 has been led by vegetables, which have shorter price cycles. With fresh arrivals increasing, vegetable prices are already lower in August. Pulses follow a cobweb cycle, where higher price incentivises more sowing, leading to higher output and low prices — a trend underway for tur dal. Above-normal rains in the rest of the kharif season and higher reservoir levels are likely to help cool rice and wheat prices. We think inflation is on track to undershoot the Reserve Bank of India’s (RBI’s) forecast of 4.4 per cent for the second quarter of financial year (FY) 2024-25 by at least 0.5 percentage points (pp).

Second-round effects are unlikely: Latest data shows a 0.2 pp rise in one-year ahead household inflation expectations, but that is still down 1.2 pp from the 2022 peak. Nominal rural wage growth is subdued at less than 6 per cent y-o-y in June, and corporate results show a moderation in salaries and wage growth of listed firms to about 6.5 per cent y-o-y in Q1 FY25, down from 9.2 per cent in FY24 and 14.7 per cent in FY23.

Core inflation remains benign: Core CPI inflation rose to 3.3 per cent y-o-y in July from 3.1 per cent in June, but the reversal was due to higher telecom tariffs, a one-off move. From a policy perspective, a rise in y-o-y core inflation, if sequential momentum remains below 4 per cent, should not be a concern. On a three-month, seasonally adjusted annualised rate basis, core CPI rose 3.2 per cent in July, and it has been below 4 per cent since June 2023 — too long a patch to call it transitory.

Geopolitical risks and oil prices: Amid the ongoing West Asia conflict, geopolitical tensions are a risk for oil prices, but this is occurring in the backdrop of a US economy, where labour markets are softening, and with still no signs of a turnaround in China’s domestic demand. Without higher global demand, any surge in oil prices due to geopolitical risks is unlikely to be sustained.

Inflation is aligned to 4 per cent: Excluding vegetables — the most volatile component of the basket, CPI inflation rose 3.3 per cent y-o-y in July, and has remained below 4 per cent since January. Our measure of the 20 per cent trimmed mean CPI, which excludes categories with highest and lowest inflation rates, also moderated to 3.3 per cent in July from an average of 3.7 per cent in the first half of 2024, and 5.5 per cent in 2023. Despite repeated supply-side shocks since 2023, second-round effects have not materialised. With nominal rural and urban wage growth in the 6-6.5 per cent range, we believe this is consistent with underlying inflation of 4 per cent, given productivity growth trends in India.

Headline versus core argument: The RBI should remain steadfast with its current framework, but just as a spike in some food prices is not a trigger for a hike, a correction in some volatile food items is also not an appropriate trigger to cut. The debate is less about headline versus core, and more about the true inflation picture and the balance of risks.

Softer growth signals: Growth has surprised to the upside thus far, but inventory buildup for passenger cars, weak commercial vehicle sales, slower corporate profit growth and slower industrial output growth, are some early signals of growth softening. In the absence of a broad-based recovery in private consumption and private capex, and with slower global growth, we believe risks to the RBI’s FY25 and FY26 gross domestic product growth forecasts are tilted to the downside.

Policy rates don’t need to stay high: Sustained low underlying inflation and early signals of softer growth suggest rising downside risks for both growth and inflation. Policy should be forward-looking.

Financial stability arguments: We believe India should follow the Tinbergen rule, with at least one tool for each target: The policy rate for price stability and macroprudential tools for financial stability. If pockets of consumer lending continue to hold up, then higher risk weightings should be announced, but monetary policy is a blunt tool to manage sectoral credit. The RBI’s recent measures are already slowing unsecured lending, and we expect credit growth to slow further, narrowing the credit-deposit growth spread.

Overall, the balance of risk around growth and inflation is shifting. Inflation risks are overstated, while emerging growth signals appear soft. Given monetary policy works with long lags, we believe it is time to recalibrate policy settings.

The writer is chief economist (India and Asia ex-Japan) at Nomura