By Anagha Deodhar
After battling the Covid-19 pandemic for over a year, the developed world seems to have started the long and arduous journey back to ‘normal’. The growth picture has gotten rosier for most of the advanced economies on the back of massive fiscal and monetary stimulus. However, the stimulus also had unintended consequences and brought the world face-to-face with an old enemy — inflation.
In most parts of the world, inflation is now a major concern. Some emerging market economies such as Turkey, Russia, and Brazil have already raised interest rates to rein in inflation. In advanced economies (notably the US), inflation has increased to multi-year highs, buoyed by the stimulus. While the jury is still out on whether the increase in US inflation is transient or not, there are now expectations that that the Federal Reserve will start hiking rates sooner than previously thought.
In India too, inflation is becoming a big worry. Just when policymakers thought the supply-disruption-led increase in inflation of 2020 was behind us, the second wave of Covid-19 hit the country and pushed the prices up again. Moreover, unlike the first wave of the pandemic, this time wholesale inflation is also increasing rapidly, making the inflation problem twice as serious. Here, we take a look at what is causing inflation in India and what policymakers can do about it.
Divergent global recovery fueling wholesale inflation
First, let’s look at wholesale inflation. The wholesale price index (WPI) slipped into the negative territory in April 2020 and remained there for the next three months as lockdown restrictions and the sudden demand shock led to a slump in wholesale prices. However, as lockdown restrictions were eased gradually and demand started limping back to normal, WPI started inching up starting August 2020. From February 2021, the increase in WPI started getting worrisome. In the March 2021 quarter, wholesale inflation averaged 5.1%, the highest quarterly average since Jun 2014. The upward trend in wholesale inflation continued in April and May 2021, as it inched further to 10.5% and 12.9% respectively, recording highest prints in the 2011-12 series.
How much of this increase in wholesale prices is driven by genuine pick up in input costs and is not just due to low base? After all, WPI in FY21 averaged just 1.3%. My analysis of the bifurcation of WPI into base effect and month-on-month momentum shows that although the base effect for Feb to May 2021 was unfavourable and added significantly to the headline WPI prints, the contribution of sequential momentum was at least as large as the base effect.
In February 2021 and January 2021, wholesale inflation inched up by 230bps. Out of this, while low base effect contributed 100bps, month-on-month momentum contributed 130bps. Similarly, during April 2021 and March 2021, WPI inched up by 260bps. Out of this, base effect contributed 100bps while month-on-month momentum contributed 160bps. In other words, the increase in wholesale prices in the recent past is driven by genuine pick up in prices as well, and is not just a statistical phenomenon.
Which components are driving this increase in wholesale inflation?
An analysis of component-level data shows that while wholesale prices have been increasing across all components, it is mainly manufactured products and fuel products that are driving the rise in inflation. More specifically, a handful of products like base metals, manufactured food, chemicals, and mineral oils are driving this increase in wholesale prices. In Apr-May 2021, base metals (copper, aluminum, lead, zinc) accounted for over one-third of the manufactured products inflation although their weight in the basket is only 15%. Similarly, food and chemicals accounted for 20% and 10% of manufactured products inflation during the said months while their weights in the basket are 14% and 10% respectively.
This shows that a handful of items are contributing disproportionately to wholesale inflation due to sharp increase in their prices. This is corroborated by other measures of input costs such as the PMI data. As the PMI press release for June 2021 noted, domestic firms are facing raw materials shortages, resulting in upward pressure on input costs. Firms are reporting higher prices of aluminium, copper, steel, chemicals, and plastics. Hence, all indicators point to rising wholesale or input price inflation due to a sharp uptick in the prices of items like metals and chemicals.
The prices of these items are increasing globally due to the large investment appetite in advanced economies on the back of stimulus. Investment activity is particularly robust in China which happens to be one of the largest consumers of base metals and other commodities. Fuel prices too are recovering, supported by faster global growth and brighter outlook.
Persistent increase in wholesale inflation may fuel retail inflation
What does the persistent increase in wholesale inflation mean for retail inflation? After all, the rate setting committee targets retail inflation and low or no pass-through of wholesale inflation to retail inflation may have less serious repercussions for the domestic economy.
There is limited literature and data-based evidence on the pass-through between wholesale and retail inflation in India. The WPI and CPI baskets are quite different: WPI basket doesn’t include services which is an important component in the CPI basket. Some also argue that in a demand-deficient economy, producers may not be able to pass on higher input costs to consumers. Hence, the sustained increase in WPI may not push up retail inflation.
While these arguments have some merit, one needs to bear in mind that rising commodity prices will almost always crystalise in retail inflation sooner or later. There are two direct channels through which rising WPI is likely to push up CPI: food and fuel inflation. Rising wholesale food prices will almost always result in rising retail food prices. In situations of supply constraints or elevated uncertainty (such as the post-Covid period), the trading margins will also increase resulting in higher increase in retail prices compared with the increase in wholesale prices.
Similarly, rising wholesale prices of fuel (represented by global prices) will lead to rising pump prices of fuel unless domestic taxes are cut proportionately. Apart from these two direct channels, there are several indirect channels through which the pass-through may happen. Higher wholesale textile prices may push up retail clothing and footwear inflation, higher wholesale prices of chemicals and pharmaceuticals may push up retail healthcare inflation etc.
Rate hikes may not curb supply constraint-driven inflation, Fuel tax cuts may
When the second wave of Covid-19 hit the country, the RBI warned that it could be inflationary. The central bank was proven right as CPI inflation started rising soon afterwards. CPI for May 2021 came in at 6-month high of 6.3%. The Monetary Policy Committee (MPC), India’s rate setting panel, also upped inflation forecasts for Q2 to Q4FY22 by 20-30 bps. However, despite the inflationary pressures, the MPC decided to hold rates steady in order to support the fragile and nascent growth recovery.
Does it mean that as per the MPC’s assessment, rate hikes at this stage may not be effective in curbing inflation? The recently released minutes of the June 2021 monetary policy shed light on this topic. Several MPC members noted that rising input prices are likely to keep core inflation elevated in the near term and monitoring supply side is important in this situation.
This hits the nail on the head. A large part of the increase in inflation during the second wave of Covid-19 came from rising commodity prices. Within the food group, higher oilseed prices are driving inflation up while rising global oil prices are driving up fuel inflation. Since majority of India’s oilseeds and fuel consumption demand is met through imports, rising international prices of these commodities has a direct and significant impact on domestic inflation.
Also, we cannot address these supply constraints in the near term. The country cannot start producing edible oil and fuel quickly to ease these constraints. Hence, the best bet to keep a lid on inflation is cutting domestic taxes on fuel. Even a Rs 2-3/litre cut in excise duty on petrol and diesel could check inflation and provide a respite to consumers. However, the feasibility of this option is questionable especially amidst pressure on government finances.
(Anagha Deodhar is Chief Economist at ICICI Securities. Views expressed in this article are personal.)