Why CPI inflation will remain high for the rest of the fiscal?

BL Research Bureau

The CPI inflation moved past the RBI’s comfort level of 4 per cent, to a 16-month high of 4.6 per cent, led by a spike in food prices. While rising growth concerns have led to expectations of a rate cut by the RBI in the December policy until now, the inflation picture may rein in further rate cuts. As such, food inflation led by a spike in onion and tomato prices and a low base is likely to remain elevated in the coming months. While the sharp moderation in core inflation (excluding food and fuel) has lent some comfort, high food inflation is likely to keep the overall CPI inflation figure over or near the RBI’s comfort level of 4 per cent.

The central bank could well pause in the upcoming policy and hold further rate cuts until inflation softens.

Why the spike

The sharp rise in food inflation has been on the cards for a while. The low base of last year was expected to exert upward pressure on food inflation. Between October 2018 to February 2019, food inflation was a negative 0.1 to 1.7 per cent, driven by a sharp fall in vegetable and pulses prices. It is on this low base that food inflation has started to creep up.

A look at the retail prices put out by the Department of Consumer Affairs, reveals that tomato and onion prices had fallen by a steep 49 per cent and 38 per cent respectively in October last year. In October this year, onion prices have spiked by 104 per cent while tomato by 78 per cent. In November so far, onion prices have risen by a sharp 164 per cent and tomato by 68 per cent.

Vegetable prices are expected to remain elevated in the coming months. For one, the low base of last year will continue to play out. Onion and tomato prices had fallen by 50-odd per cent in November last year. Onion prices, in particular, had fallen substantially until March 2019. Also, states such as Rajasthan, Maharashtra, Gujarat, Karnataka and Madhya Pradesh witnessed excess rainfall this year, impacting Kharif crops. This is also expected to keep food and pulses inflation high in the coming months until the end of the current fiscal. Pulses inflation which was negative through the second half of last fiscal has been moving up sharply over the past three to four months (11.7 per cent in October), also leading to higher food inflation.

Weak core inflation

The worsening slowdown has led to a sharp fall in core inflation, led by health, personal care and household goods and services. From about 5 per cent levels in March 2019, core inflation has fallen sharply to 3.5 per cent in October. The fall in rural core inflation has been sharper, indicating the weaker demand in rural areas. While core inflation can moderate in the coming months, a sharp rise in food inflation is likely to keep the overall CPI inflation at about 4 per cent or even higher in the coming months.

RBI worries

From the RBI’s perspective, the higher CPI inflation in October and in the coming months, pose several challenges. After the 135 bps cut in repo rate so far, there were still expectations of a further rate cut, given the weak demand outlook. The latest IIP growth numbers only indicate the worsening economic slowdown. In September, IIP contracted by 4.3 per cent, led by dismal performance in the manufacturing, mining, consumer durables, infrastructure/construction---not to mention the steep 20 per cent contraction in capital goods. Nearly all components within IIP have turned negative. India Inc, September quarter performance also indicates weak demand with a fall in revenues. The only silver lining has been the lower corporate tax rate that has given a boost to profits.

The RBI will now have to walk the tight rope of balancing growth and inflation expectations. While there is a compelling case for a rate cut in the December policy owing to a gloomy economic growth outlook, elevated levels of inflation can limit the rate action.

As such, the transmission of rate cuts so far has been weak, and while banks moving to repo linked loans in October could lead to faster reductions in lending rates, it may not help much. For one, various banks have added different spreads to their benchmark. Hence, the final effective lending rates may still not come down significantly. Also, banks have to reset the benchmark every three months, and therefore some banks may even take time to pass on repo rate cuts. After the sharp 135 bps cut in repo rate, the RBI may wait to see how the transmission pans out before cutting rates further to boost lending.

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