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Posted by: Deepa Vasudevan on Thu, Jan 24th, 2019

Low Inflation, New Problem

The next review of monetary policy is due on 7 February 2019, and markets are anticipating a less restrictive monetary regime. At the very least, the monetary stance is expected to change from “calibrated tightening” to “neutral”; and some are even hoping for a small rate cut! This optimism stems from the ridiculously low levels of inflation seen in FY19 so far. During Apr-Dec 2018, average CPI inflation came in at 3.8% and average WPI was at 4.8%.

The main reason for low inflation was subdued food prices, which averaged 0.5% in Apr-Dec 2018. Combine this with moderating fuel prices, and we have a situation of sub-4% headline consumer inflation, a number that is gratifying in a country that is more used to periodic episodes of high food inflation (Pic 1). 

 Pic 1: Headline and Core Inflation


Unfortunately, core inflation- inflation stripped of volatile items like food and fuel- remains stubbornly high at 5.5%-6%. A quick look at the non-food, non-fuel components of CPI provides the answer- core inflation has been rising due to a steady rise in health and education inflation (Pic 2). This is not surprising- healthcare inflation has been outpacing general inflation for more than two years now- for reasons ranging from high cost of medical technology, over-prescription of medical services, to an increase in lifestyle-related chronic ailments. Rising cost of education is attributed to strong demand for quality education fuelled by rising incomes, aspirations and loan availability. In fact, the overall uptrend in service inflation, as captured in core inflation, reflects the growing demand for services in both rural and urban areas.

 Pic 2: Inflation: CPI Components


This poses a problem for RBI: its monetary anchor (headline CPI inflation) is low, and calls for an easier monetary policy, but high core inflation suggests just the opposite. Why should RBI care about core inflation? Because core inflation, if sustained and prolonged, is almost certain to feed into headline inflation. Studies have shown that headline inflation tends to converge to core inflation over time. In other words, today’s high core inflation may become tomorrow’s high overall inflation!

Thus the Monetary Policy Committee faces conflicting signals when it meets next month. On the one hand, food prices are low, fuel prices appear to have settled down, and the exchange rate is relatively stable. Hope for an investment revival is building up on the back of a steady increase in capacity utilization and a pick-up in bank credit. All these call for monetary easing.  

On the other hand, sticky core inflation and the possibility of fiscal expansion through farm waivers and other pre-election give-aways are likely to put upward pressure on inflation, and stop RBI from cutting rates.  

The RBI may resolve the issue by keeping policy rates constant, while ensuring that the system has adequate liquidity in the traditionally tight fourth quarter; this will give it more time and additional datapoints till the next meeting. Alternately, it may go in for a token rate cut or CRR cut to encourage bank lending. At this point, further tightening does not seem likely. That itself should be good news for markets!

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