India’s economy is a paradox with core inflation rising even when consumption demand doesn’t seem to have revived fully from the pandemic. The latest headline inflation print for January at 4.06% is a 16-month low but inflation excluding food and fuel rose to 5.7%. Core inflation tends to be sticky and this makes it a bigger foe than perceived.
Indeed, analysts have been warning about the pressure points in non-food inflation, especially services wherein enterprises have been able to hike prices at the retail level. These price hikes have been partly to offset the cost of the pandemic on business. Pranjul Bhandari, chief India economist at HSBC had flagged services inflation as a looming threat in a report as early as December. What makes it worse is that services are not tradable and prices cannot be tamped down through imports, something that is possible for goods, according to Bhandari.
We should note that the core inflation is elevated in a year that would see the economy shrink by at least 7.5%. What’s more is that the recession is led by a contraction in consumption demand. What this means is that India’s core inflation is immortal and even a collapse in demand doesn’t seem to temper it down. While it may seem puzzling, there is a simple explanation for the same. While in theory a demand collapse would result in prices dropping, imperfect markets make this relationship complicated. This was pointed out by Jayant Varma, a member of the RBI’s monetary policy committee at the December meeting. Varma had said that in several sectors an oligopolistic core comprising of a handful of large companies have been able to exercise pricing power and simultaneously get benefits from low interest rates. The divide between large companies and small enterprises has been stark in the earnings reported by listed companies as well.
It is clear that core inflation has risen because of pricing power and the power to hike prices has come due to a reduction in supply. Simply put, small companies that collapsed due to the pandemic have caused a reduction in the supply and large companies have been able to hike prices. Whether these supply side issues get resolved through small enterprises again coming back to business is something to watch for. In the meantime, the RBI has anticipated the pressure on core inflation. As such, the central bank expects headline inflation to be 5.0-5.2% in the first half of FY22. Given that it is within the flexible inflation target range, the central bank still has the luxury to ignore the core inflation pressure. “Overall, RBI will be faced with significantly difficult policy choices as economy continues to revive and core inflation remains in an upward trajectory alongside deluge of capital inflows,” said Upasna Bhardwaj, senior economist at Kotak Mahindra Bank in an email. More than FY21, the next year would test the RBI’s skills in nurturing a growth recovery amid an unbending inflation.