The ghost of inflation no more?

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The issue of inflation is important, and one has devoted considerable amount of energy into it over the last few months. There has been constant chatter around the prospects of high inflation over the last few months even though inflation has been much lower than our historical trends (although it was a bit high relative to the inflation target). However, inflation has since then moderated significantly as it is now at a four-month low of 5.3% – well within RBI’s target of 2-6 per cent.

It is now becoming clearer that the bulk of the inflationary impulses in the economy were because of supply disruptions – much of which have begun to gradually ease. Thus, in the absence of inflationary impulses, there is no meaningful gain in hiking rates prematurely even as supply chains attempt to repair themselves. Doing so can only delay the process which will further create shortages that may again spike prices for some articles. That Indian inflation is moderating swiftly further reinforces the view of ‘transitory’ inflation as an implication of the pandemic. This should give hope to some other economies that are still witnessing high inflation.

The moderation in inflation is a welcome news to Indian consumers that have been under pressure since the start of the pandemic. Very likely, we may witness a restoration in nominal incomes which would imply restoration of wages to the pre-pandemic levels. In most sectors, this has already happened – while in some sectors even bonuses have been restored.

The key question that many have pertains to the future trajectory of inflation – especially with the context of some recent comments regarding food inflation playing out over the coming months. With decent monsoon and a robust rural economy, it seems unlikely that food production will fall short substantially to affect food inflation. In fact, prudent and modest 2% hike in MSPs will prevent food inflation thereby keeping overall CPI in check. Therefore, there is a possibility that RBI’s inflation forecasts may actually be higher for 2022 than the actual inflation in 2022 – unless the RBI revises its inflation forecasts for the coming year. As a matter of fact, many forecasters will have to gradually revise their inflation forecasts for India as it goes back to a situation of close to 3-4 per cent inflation.

At this moment it is important to talk about the Wholesale Price Index, which captures the prices of commodities that are largely bought by producers in an economy. The WPI inflation has been high since the last few months and many have conveniently used this metric while talking about inflation even though the CPI is a better indicator to track inflation faced by consumers. The issue with WPI inflation was because of higher commodity prices as most economies began to open up around the same time. WPI Inflation too was always argued to be transitory, and we shall witness this over the next few months as more data points emerge.

But beyond the transitory versus permanent debate, the developments in China will play a major role in determining inflation. Their real estate sector which accounts for close to 24% (when one includes related industries) of their GDP is bound to be affected by the aftershocks of the Evergrande crisis. Those who aren’t aware, Evergrande is one of the largest real estate developers in China which is on the verge of bankruptcy. Even if Evergrande manages to repay the bonds, real estate growth in China will slow sharply thereby restricting the growth of Chinese economy and the demand for steel, cement and other commodities. Consequently, the price of commodities may begin to taper over the coming months. This will be similar to the post 2008 economic recovery as even at that time many were concerned about inflation, but what followed was a period of persistently low inflation.

But what about inflation expectations? Well, Indian households have always expected inflation expectations but the recent question has been on whether such expectations are important as determinants of inflationary outcomes. Conventional macroeconomics would suggest a definite yes but the real world evidence is mixed on this issue. In fact, just recently a paper by the Jeremy B. Rudd suggested that we may overemphasize the importance of inflation expectations as a determinant of inflation.

Good monsoon, easing of supply constraints and muted demand for commodities in the aftermath of Evergrande crisis suggest that inflationary impulses will continue to ease over the coming months. This augers well for India and its consumers over the coming months.