By Pranjul Bhandari
Weak rural incomes explain 70% of India’s disinflation; throwing up a double challenge for authorities
It is well acknowledged that inflation has fallen dramatically this year. More nimble supply management by the government, increased direct food procurement by the private sector and more efficient transport logistics are likely contributors to low food prices.
But this is not the entire story. A substantial part of the disinflation is also led by temporary factors. And when these reverse, so will a part of India’s disinflation. When could that be? To get to the answer, we first need to understand the dynamics.
We find that 70% of the disinflation has been led by the fall in rural inflation. After several years of rural inflation remaining firmly above urban inflation, it has recently fallen below it. The ‘excess’ inflation in rural India vis-a-vis urban India (calculated as rural inflation minus urban inflation) has fallen across all components — food, core and fuel. Core inflation is simply overall inflation after removing the food and fuel components.
A key reason why rural inflation has fallen rapidly, in our view, is weak rural demand. Growth in rural wages has been slowing. We do not have comparable wage data on urban demand, but if consumer sentiment tells us something about it, then urban demand is doing better than rural demand.
This explains the fall in both excess core and excess food inflation in rural India. The former is an output gap argument. The output gap becomes positive when actual growth runs faster than the potential of the economy, and negative when actual growth runs slower than the potential. The output gap is likely to be negative in rural India and positive in urban India, thereby pulling down the ‘excess’ core inflation in rural India.
The rural food disinflation is based on what is known as the ‘Engel curve’ argument (named after a 19th century German statistician). When incomes are low, demand for expensive food items (for instance milk and animal proteins) tend to be weak, leading to a fall in their prices. There is good evidence from rural India that this is what is happening.
All told, the weakness in rural growth (versus urban), seems to be pulling rural inflation lower (more than urban).
To be fair, things are not that bad. On a sequential (quarter-on-quarter, seasonally adjusted) basis, rural incomes have been improving a little. This has been driven primarily by non-agricultural activity, particularly government sponsored construction, mainly housing, rural roads and irrigationNSE 0.75 %. Alas, the improvement in rural wages is not good enough. It is just a return to trend growth after lying below it for a while. And, more importantly, trend growth is falling.
So far, increases in minimum support prices (MSP) have not been able to raise food prices (and thereby wages). If public sector construction slows following the national elections in 2019 (as the government shifts its focus back to fiscal consolidation), we believe that rural incomes, and with them food inflation, will remain contained for longer.
This throws up two challenges for policy makers. How do you improve rural incomes when food prices are low, while keeping the fiscal deficit in check? This may need some action sooner rather than later. Focussing on crop substitution, agricultural exports, and disintermediation of the middle man could help raise farmer incomes.
The central bank may also face a challenge. Inflation is well behaved now. But will it be able to keep it contained once rural incomes begin to rise? That indeed, will be the real test for an inflation targeting RBI. Luckily, that problem seems to have been pushed to a later date.
(The author is Chief India Economist at HSBC)