Over the past several months there has been much concern, and rightfully so, over the trajectory of inflation. The most recent data, however, seems to indicate that retail inflation has possibly peaked and is now likely to trend downwards. But, it would be wise to exercise caution. The latest data, while providing useful nuggets of information about price trends in the economy, challenges some of the widely held conceptions about inflation, and gives mixed signals about its trajectory. Five broad trends emerge.
First, much of the discussion on the causes of high inflation in India has in recent months centred around the Russia-Ukraine war. The sharp rise in commodity prices as a consequence of the war is considered to have been largely responsible for the spurt in inflation this year, pushing it beyond the upper threshold of the RBI’s inflation-targeting framework. There is some truth to this. For instance, India’s crude oil import price rose from $84.67 per barrel in January to $112.87 in March, and further to $116.01 in June. The ripple effects of higher commodity prices have been felt across the economy.
But, thereafter, commodity prices have been on a downward trend. Case in point: India’s crude oil import basket price has fallen by around 20 per cent since then to less than $92/barrel in November. Yet, over the same period, core inflation has edged upward. If high core inflation in the months after the beginning of hostilities was an outcome of the passthrough, either in part or completely, of the Ukraine war, then the decline in commodity prices since then should have led to a moderation in core inflation. But that does not seem to be the case. If anything core inflation has firmed up in recent months — from 6.1 per cent in June to around 6.6 per cent in October. Perhaps, the effects will be visible with a lag.
Second, there are indications that inflation is getting more generalised across both the formal and informal segments of the economy. One indication of this comes from the clothing and footwear category — a highly fragmented industry with the presence of both formal and informal segments. Inflation in this category has averaged 9.7 per cent over the past eight months (March-October), up from 7.7 per cent in the eight months before that.
Another possible indication comes from rentals. Rental inflation in India had tended to remain largely range-bound over much of the past few years. However, there has been a steady uptick over the past five months. It is possible that this is a one-time correction — landlords who would have held back on raising rents during the pandemic would now be adjusting for lost time. But as this category has the highest individual item-wise weight in the inflation index, any movement in either direction, however small, would have a large impact on core inflation.
Third, during the pandemic, supply-side disruptions had caused goods inflation to rise, even as services inflation remained relatively muted owing to risk-averse behaviour by consumers and restrictions on high-contact intensive sectors. But as activities normalised, there was an expectation that services inflation would see a strong pick-up. The recent data indicates that this has not been the case. While services inflation has risen, it remains considerably lower than goods inflation, perhaps owing to a combination of lower cost-push pressures, more slack and less demand.
Fourth, to what extent prices are rigid on the downside will depend not only on how demand fares now with monetary conditions having been tightened, but also on the extent of competition in the economy, among others. After all, greater market concentration creates conditions for greater pricing power. A badly damaged non-corporate sector (MSMEs) would have led to ruptures in the low-cost economy, increasing the pricing power of the corporate sector during this period. This would reflect in healthy corporate margins. It is conceivable that these forces are also at work in the clothing and footwear category — a sector that witnessed perhaps the largest firm death rates during the pandemic, creating geographical pricing power for both the surviving formal and informal firms.
However, preliminary data on the second quarter results seem to suggest that firm margins have begun to come under pressure. Perhaps, as the non-corporate sector recovers, greater competition will limit corporate pricing power. As per a recent Crisil report, almost all the formal MSMEs are likely to recover to their pre-pandemic level of revenue by this year. Though whether the same holds for the informal MSMEs is difficult to gauge.
Fifth, it seems unlikely that this spurt in inflation will translate into a wage-price spiral. Unlike in countries like the US, price pressures in India coexist with weak, not tight, labour market conditions. Inflation in India is not a consequence of a strong economy. Wage growth in the large informal rural economy has been lower than inflation. And while some skill-intensive segments of the urban formal labour force may be able to exercise some bargaining power, the labour force participation rates suggest continuing slack in urban labour markets.
How these forces play out will determine to what extent non-food prices are sticky on the downside. The RBI expects inflation to edge downwards from 6.5 per cent in the third quarter to 5.8 per cent in the fourth quarter and then to 5 per cent in the first quarter of the next financial year (2023-24). But, considering its forecasting errors in the past, it is possible that the central bank continues to underestimate the price pressures in the economy. While inflation may have peaked, it is far from being quashed.