There is a mystery of sorts. As input prices and demand soften, goods inflation, globally, is falling. But in India, goods inflation is rising. With pent-up demand for high-touch services still having some way to go, services inflation, globally, remains elevated. In India, services inflation is falling. What’s going on? We believe there is a very Indian story brewing which must be told.
It all started back in late 2021 when consumer spending in rural areas weakened. Through 2022, inflation accelerated, the March heatwave took hold, and monsoon rains proved erratic, leading to a poor harvest and a battering of rural incomes. Sales of two-wheelers and consumer non-durables weakened through the year. Over this time, urban demand improved. As lockdowns ended, urban jobs came back. Workers who had gone home during the pandemic period returned to the big urban centres. Every time a worker moved from rural to urban India, wages went up 2.5 times. Higher incomes meant strong consumption. Against this backdrop, the rural demand weakness showed up all the more starkly.
Then, the weather turned. In the last few months of 2022, the reservoirs began to fill up, and winter farm sowing picked up. With more hands needed on the ground, agricultural wages rose. In fact, after adjusting for inflation, they crossed pre-pandemic levels. Higher incomes showed up in some rural indicators too, including consumer non-durables production, which rose quickly from October levels.
By end-2022, the shift in labourers moving back to the cities was almost over, as was the growth stimulus powered by it. After that, indicators of urban demand, such as consumer durables production, began to weaken. To be fair, rural demand is still barely rising, while urban demand is slightly softening. Neither is dramatic. But it is clear that the tables are slowly turning.
Something similar is happening in the informal sector, which employs about 80 per cent of India’s labour force, divided equally between agricultural and non-agricultural workers. Informal-sector firms have faced back-to-back economic shocks: First, the lockdowns and, second, the commodity price hike. We find that small firms underperformed large firms through the pandemic, losing market share, becoming less profitable, and paying their staff less. Of the small firms, the informal ones were hardest hit. Over the past few months, coming out of the lockdowns and last year’s commodity price jump, the prospects for small firms have improved. The burden of high input costs has fallen, and the salaries of these firms’ staff are gradually rising. Informal sector incomes appear to be rising, again showing up in indicators such as improving the production of non-durable consumer goods. There are strong interlinkages between the rural and the informal sector – so, in one sense, we use the two terms almost interchangeably. First, about three-fourths of the country’s informal sector workers live in rural India. Second, much of what rural Indians consume is produced in the informal sector. But it is also important to note that a quarter of informal-sector workers live in urban India, where they are also seeing improvement in incomes.
How will the informal and rural sector demand trends for goods and services evolve?
About 20 per cent of rural households are landed (own more than one hectare of land). Much of their income comes from cultivation. On the other hand, much of the income of the 80 per cent of households that are landless (owning less than one hectare of land) comes from wages. These wages are split between agricultural (roughly 40 per cent of households) and non-agricultural activity (the remaining 40 per cent of households).
Till six months ago, each of these groups was doing poorly. Now, the 40 per cent of households that are agricultural wage earners have begun to do better. If the winter crop does well and the 20 per cent of landowners sell their crop over the next few months at prices which are trending higher than the government’s minimum support prices (MSPs), their incomes will also rise.
So, what will these households buy? We find that rural and informal sector consumption is skewed more towards goods rather than services, and there too, more towards consumer non-durables rather than consumer durables. The rise in the more goods-heavy demand from the rural and informal sectors is the key reason why overall goods demand is outpacing services demand. And manufacturers are taking this opportunity to build back profit margins, after sharp losses last year. This explains why retail inflation hasn’t fallen as much as wholesale inflation and why the margins of manufacturers are rising faster than the margins of service providers. And most importantly, it explains why goods inflation is outpacing services inflation.
The high inflation reading of 6.5 per cent for January took many by surprise. As we await the winter crop, due in March/April, food prices, particularly of wheat and milk, will likely remain elevated. But our bigger worry is that, even if the winter crop is good, the rural demand it stokes will come in the way of disinflation as producers continue to rebuild their margins, pressuring core inflation. And, if the winter crop is weak due to last-minute weather disruptions, particularly as temperatures have begun to rise quickly, food inflation could remain high – even if rural incomes and core inflation fall.
Either way, we expect inflation in FY24 to tread higher than what most are now expecting (the consensus of estimates). This has implications for the RBI’s rates policy. Over the next few meetings, we believe the RBI’s rates will be strongly impacted by the Fed’s actions, global inflation, and any likely pressure on the rupee. And, based on our assessment, domestic inflation may not provide much breathing space, either. The message is clear. Brace for further RBI rate hikes over the next few months.
The writer is Chief India Economist, HSBC
The high inflation reading of 6.5 per cent for January took many by surprise. As we await the winter crop, due in March/April, food prices, particularly of wheat and milk, will likely remain elevated. (Illustration by C R Sasikumar) 
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