With inflation falling, will the RBI relent?

Given that the market was already factoring in very low inflation for few months to come, the decline in CPI inflation to 1.5 per cent in June from 2.18 per cent in May did not take the market by surprise.

But given that the June inflation is way below the RBI’s projection of 2-3.5 per cent for the first half of this fiscal, the clamour for rate cuts has only gotten stronger. Will the RBI yield this time around?

Aside from the steep fall in food inflation, which has been downplayed by the RBI time and again, the steady and consistent fall in core inflation (non-food and fuel) could find favour with the central bank.

However, while the recent data may force the RBI to consider a token 25 basis point rate-cut, it is not a given. Monsoons, HRA increase under the Seventh Pay Commission, temporary impact of GST, base effect trickling in, and fiscal risks emanating from farm loan waivers by States can still exert upside pressure on inflation in the second half of this fiscal.

The RBI, rigid on its 4 per cent target (unwilling to use the 2 per cent leeway) could well choose to hold rates in the upcoming August policy and consider rate cut, if any, in the October policy.

Majority of the members of the Monetary Policy Committee (MPC) that voted in favour of holding rates, cited uncertainty over the sustainability of the April inflation, core inflation remaining sticky, rising rural wages and possible fiscal slippages in the form of farm loan waivers as key reasons for adopting a wait-and-watch approach.

Given that the MPC now has data for two more months — May and June — the argument of not able to rely on a single data point, has waned. The trend over a three-month period can offer a more durable picture of inflation.

But given that the focus has been on steering the trajectory of inflation towards its target over the medium term, rather than past data, how inflation trends over the second half of the fiscal holds more relevance now.

The RBI has projected the CPI inflation at 3.5-4.5 per cent in the second half. Will inflation deliver to the central bank’s expectations?

Over the past year, the sharp fall in CPI inflation has been led by food that has a 45 per cent weightage in the CPI basket. The fall in food inflation from 7.46 per cent in June 2016 to a negative 1.17 per cent in June 2017, has been due to the sharp drop prices of vegetables and pulses.

From 14.8 per cent in June 2016, vegetable inflation slipped into the negative zone since September 2016. For June 2017, it stood at a negative 16.5 per cent. Similarly, pulses inflation which was 26.8 per cent last June is now a -21.9 per cent.

Oversupply of food due to bumper crop, alongside rising imports have led to the steep fall in food prices. Will this sustain?

The prices may continue to remain subdued for few more months aided by excess supply, good monsoons and low prices globally. But over the medium term (the RBI’s key focus), structural issues can weigh on food inflation, as in the past, leading to volatility and reversal in the downward trend.

Food inflation in the past has known to be volatile given the weak food supply management and procurement by government agencies. Between 2012 and 2014, for instance, food inflation shot up to as high as 16.6 per cent (November 2013) to as low as 2 per cent (November 2014).

Since 2015, though, food inflation has remained within a small band of 5-6 per cent, but for the sharp fall in recent months.

Some market players suggest that some of the Centre’s efforts to iron out issues in the food supply management has paid off. But there are still some challenges.

In the current year (2016-17), farmers have been dealing with the problem of plenty. This has led to food prices falling sharply, below MSPs (minimum support prices). Farmers are likely to move away from oilseeds production in the current year. This will again lead to prices going up. This recurring trend as in the past could continue to drive sharp price movements in pulses.

Also, the Centre has already raised MSPs across cereals, pulses and oilseeds for 2017-18. This could lead to some upside in food prices over the medium term (as pointed out by Urjit Patel in the MPC minutes). Nation-wide farm loan waivers too can lead to increased demand and rise in food prices over the medium term.

Hence, while some of the fall in food inflation has been structural, there are other components that can keep food inflation volatile.

What could nudge the RBI to turn accommodative though, is the steady fall in core inflation in recent months. Components such as health (5.8 per cent weight in CPI), recreation and amusement (1.6 per cent), education (4.4 per cent), and transport and communication (8.5 per cent) — all have witnessed a consistent fall in recent months.

However, sustainability of the downward trend will be closely watched by the RBI and will hold the key for further rate cuts. Post GST, higher taxes on clothing, health, medicines, education, housing and mobile services will likely exert upside pressure on inflation. Also, housing, which has a 10 per cent weight in CPI, has more or less remained sticky.