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March 28, 2019

Indian Economy: Melting inflation

After an extended soft run, food inflation is poised to harden, even as core remains sticky


Food has been the inflation slayer, and not so much policy. That is what our analysis of India’s feeble inflation in the past few years, which has surprised regulators and analysts alike, finds. In the past three fiscals, it was low food inflation – normally an idiosyncratic factor – and not policy measures such as inflation targeting by the Reserve Bank of India. Food inflation, with 40% weight in Consumer Price Index (CPI), dropped from 4.9% to 0.2% during fiscals 2016 to 2019. But why is food treated as the idiosyncratic factor in inflation literature? Because it is not as much impacted by economic slack as by volatile factors such as monsoons, global prices, and supply shocks.


Indeed, this pattern is not new. Since 1991, almost all the cyclical ups and down in inflation correlate with similar cycles in food inflation. The most notable of them is the period between fiscals 2000 and 2006, when the overall CPI and food inflation averaged 3.9% and 2%, respectively. Core inflation (inflation sans food and fuel) has remained sticky, within 4.4-5.5%, in the past five years. It has contributed almost 80% to overall inflation this fiscal. With gradual increase in global crude oil prices as well as their linkage to domestic fuel prices, fuel inflation has been on the rising trend in the past four years. On the other hand, implementation of Goods and Services Tax, normally associated with rise in inflation, doesn’t seem to have influenced overall inflation. Impact of demonetization on inflation is still not well understood. It is too early to decisively assess its impact, as it has been in operation for a little less than three years. A study by Dholakia (2018) points towards some softening of inflation persistence in India. This implies weakening of second round effects of price shocks from food, fuel, or exchange rates. Household inflation expectations, which are explained by food and fuel prices and are adaptive in nature, continue to remain elevated.


All this converges to the finding that it was largely serendipity that has brought down inflation of late. The impact of policies is less conclusive. That also means inflation will inch up once we run out of luck. The good news is, despite an expected pick-up in food inflation, we peg consumer inflation at 4.5% in fiscal 2020, well within the central bank’s target. Somewhat lower persistence means that pick-up in food inflation will not necessarily lead to a situation of sustained high overall inflation. Our call is based on the following: (i) food inflation, which has remained unusually low, is expected move up; (ii) the World Bank projects food prices to rise in 2019; (iii) core inflation is likely to remain sticky, given mild upside from a consumer-friendly budget, implementation of Pay Commission hikes by more states and other populist measures such as farm loan waivers; (iv) fuel inflation is expected to remain soft, as global crude oil prices have come off their recent peak in October 2018, and are unlikely to rebound sharply this year, given the slowdown in global growth prospects.