It is well known that when a negative output gap begins to close, it starts to push core inflation up. Indeed, we estimate that India’s output gap has been gradually closing, and will turn positive in late FY19. This will add to inflation, more so, if one considers that India’s investment rate has fallen in recent times, lowering potential growth, and making any cyclical recovery inflationary. No wonder then that, as growth recovered from 6% in H1FY18 to 7.4% in H2FY18, core inflation galloped from 3.5% to 5.2%. Our core inflation model had shown that the output gap, while still significant, is not as important in determining inflation as before; though this is not so for the health and education sectors.
Health and education inflation showed that the importance of the output gap never really fell for them. And, furthermore, sector-specific output gaps have turned positive a long time ago. All of this means that these sectors suffer from larger supply-side bottlenecks, which makes them inflationary rather quickly, during periods of growth recovery. Looking deeper, we find that the services components within health and education have turned more inflationary than the goods components. This is understandable, given that price pressures in services cannot be easily traded away. Cyclical growth will finally determine how high core inflation rises.The big question then is, by how much can all of this push up inflation? Since it is cyclical growth that pushes up the output gap, and adds to inflation, the impact on inflation depends on the strength of the cyclical recovery. While we believe that growth will rise in FY19 (to 7.3% from 6.7% last year), much of it is due to a favourable base in H1. Growth momentum on the ground will only rise gradually. By our calculations, the negative output gap widened by a large 50bps in FY18. We expect it to narrow by about 30bps in FY19. The coefficient on the output gap from our inflation model suggests this will add 15bps to inflation.
Normalising core inflation
FY18 was an out of the ordinary year, with core inflation falling meaningfully (as producers resorted to steep discounts in the run-up to the implementation of GST). That driver of inflation will normalise in FY19. We find that core inflation contributed about 30bps less to headline inflation in FY18, than the recent trend (two year average) would suggest. Of this, we find that 20bps was due to lower growth (i.e., a wider output gap). We attribute the remaining 10bps to GST related disruptions.
Prima facie, the new MSPs imply an average 22% (versus 6% last year) rise in kharif MSPs across all crops and should impact inflation. However, the actual impact will depend on how much of the crop produce is eventually procured at the higher MSPs. In terms of the impact on inflation, the following scenarios could pan out:
*Low procurement: Procurement is in line with past years, good for paddy (rice), weak for other crops. We assume that for paddy, the government will procure enough to close about 70% of the gap between market price and MSP. For the remaining crops, we assume it will be able to close only about 20% of the gap. This would add 30bps to CPI inflation in H2FY19, and cost 0.1% of GDP.
*High procurement: The government does a better job than it has done in the past, perhaps by enlisting private procurers. We assume that it is able to drive all market prices closer to the MSP levels. This would add 70bps to CPI inflation in H2FY19, and cost 0.2% of GDP.
*Medium procurement: The government does a good job in procuring paddy, but not much for other crops. For other crops, it compensates farmers for the difference between market price and MSPs. While this will add 40-50bps to inflation in H2FY19, the impact of fiscal could be higher at 0.3% of GDP. We are pencilling in the ‘medium procurement’ scenario that will add c25bps to inflation in FY19 (c50bps in H2).
The import-led inflationary impact of the rupee depreciation is likely to be a bit nuanced. There is substantial evidence in academic literature that exchange rate pass-through (ERPT) to domestic inflation has fallen significantly in emerging markets, especially India. For India, the two main reasons, in our view, are as follows:
*Adoption of flexible inflation targeting has led to a decline in inflation variability since 2014, largely by anchoring inflation expectations better. Also, exchange rate volatility has fallen considerably over the same time. The combination of the two is believed to typically lower the degree of exchange rate pass-through to domestic consumer prices.
*Reduced trade openness of the Indian economy has also lowered the vulnerability to external shocks through exchange rate movements. Hence, ERPT is expected to have fallen in recent years.
Another, more controversial reason for lower pass-through is the rise of local currency pricing (LCP). LCP implies that in the event of depreciation in the importing country’s currency, the exporting country’s firms adjust the prices downward to retain market shares. This, in turn, compresses ERPT. Nevertheless, given India imports over 80% of its oil needs, and almost all of its gold demand, ERPT is expected to affect CPI inflation meaningfully.
RBI’s April Monetary Policy Report estimates that for ~5% depreciation in the rupee, domestic inflation could edge higher by c20bps. This is in line with the coefficient we calculate as well. If for the full year, the rupee averages 68.5 (where it stands now) to the dollar, implying a c6% depreciation, it could add 25bps to FY19 inflation.
Rising oil prices
The government has passed on much of the global oil price increase to retail prices . We estimate that about 80% of oil price increases over the last year are now reflected in pump prices. We assume that this will continue over the remainder of FY19. We assume that oil prices will average $75/bbl in FY19 (versus $58/bbl in FY18). RBI estimates that in the event of full pass-through, every $10 per bbl change in oil prices will add 30bps to inflation. Assuming c80% pass through, we estimate global oil to add 40bps to headline inflation
What does this mean for policy repo rate?
With the pressures on inflation stacking up, CPI inflation is expected to reach 5.2% in FY19—higher than RBI’s 4% target and a tad closer to the upper end of the 4% ±2% tolerance zone. Given the sharp move in the rupee towards end-June, and the merits of moving sooner on rate action, we have brought forward our expectation of a 25bps repo rate hike to August (from October). We have added another 25bps rate hike in 4Q 2018. With this, the repo rate will stand at 6.75% by end-2018.
What this means for liquidity?
In our view, moderate rate hikes to control inflation, and domestic liquidity injections to keep liquidity neutral and support the genuine growth needs of the economy, can coexist. And, as long as liquidity is neutral (and not venturing towards surplus), it will not be inflationary, nor will it play a decisive role in weakening the rupee.
Where will inflation go in FY20?
Come FY20, the pressure on some aspects of inflation will be lower. Headline inflation is likely to fall from 5.2% in FY19 to 4.6% in FY20. In fact, inflation is likely to go back to the 4% range in the H2FY20. Some of the pressures anticipated in FY19 are likely to abate and we believe that the domestic case for further rate hikes in FY20 will be weak.
The Author is Chief economist, India, HSBC Securities and Capital Markets (India)
Views are personal
Co-authored with Aayushi Chaudhary and Dhiraj Nim, associates, HSBC Securities and Capital Markets (India)
Edited excerpts from HSBC Global Research’s Anatomy of India’s Inflation (July 6, 2018)
Source: Financial Express