Inflation respite

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But food prices can pose policy challenges

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The members of the Reserve Bank of India’s (RBI’s) Monetary Policy Committee (MPC) should be pleased to see the decline in the inflation rate. According to the official data, released on Monday, the consumer price index-based inflation rate for October declined for the second consecutive month to a five-month low of 4.87 per cent, compared to 5.02 per cent in the previous month. The decline was driven mainly by the base effect and moderation in the price of clothing, footwear, and transport. Although the inflation rate for vegetables, which had pushed up the headline rate in previous months, declined to 2.7 per cent in October, the overall food inflation rate remained elevated at 6.61 per cent. In the food basket, while cereal inflation remained in double digits, the increase in the prices of some vegetables, such as onion, suggests that the relief in the October numbers may be short-lived.

The MPC is scheduled to meet early next month and will have to work with the October inflation numbers. While the decline in the headline rate is certainly a relief, it is worth noting that the number was still marginally above market estimates, and is likely to go up again in the coming months. The uneven distribution of the monsoon will have implications for final kharif output and low reservoir levels can affect the winter crop. Thus, despite core inflation moderating and remaining closer to the medium-term target of 4 per cent, sustained higher food prices are likely to keep the headline rate elevated and pose policy challenges for the MPC. The committee expects an average inflation rate of 5.4 per cent this financial year. High food inflation sustained over a longer period can affect inflation expectations. However, as things stand, a low core inflation rate and moderation in household inflation expectations suggest that the second-round effect has been limited thus far. But this can change over time.

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The Union government on its part has put restrictions on the export of several food items to contain prices. While this strategy will help contain inflation in the short run, it will cost the farm economy in the medium to long term. Aside from food prices, another risk to inflation could emerge from supply disruptions owing to geopolitical tensions in West Asia. Although public-sector oil-marketing companies have practically stopped adjusting pump prices to international prices, a sharp increase in crude oil prices may leave them with no choice but to raise retail prices. Further, advanced economies, particularly the US, are projected to keep policy interest rates higher for longer. This means that the yield difference will remain low and affect capital flows. While the RBI has reiterated its position that monetary policy is determined by domestic conditions, depreciation in the rupee because of capital outflows can influence inflation outcomes.

Overall, in the given situation, the MPC will be expected to maintain the status quo on the policy rate in the December meeting. The increase in the policy repo rate by 250 basis points in the current cycle is still working through the system and a further increase at this stage may not have the desired impact on the drivers of inflation like food prices. However, the MPC will need to remain vigilant and be prepared to act if inflation outcomes and projections deviate from the projected path.