Inflation outlook becomes more uncertain

It’s like believing that the cobra has been broken up; he can now play to the tune of the snake charmer. Are you okay?

On June 4, the RBI revised upward its CPI inflation forecast for fiscal 2022 by just 10 basis points, to 5.1%, reassuring the market that the accommodative stance of monetary policy will continue for as long as necessary to relaunch and sustain growth on a sustainable basis. However, the minutes of the MPC meeting, released on June 18, reveal the obvious concerns of some members. Since the review, data for May showed CPI inflation at 6.3%, well above market consensus.

Yet most economists believe that inflation simply cannot hold itself – the odds are clearly against any breakout, the output gap is too large, the unemployment rate is very high. There is also this strong belief that inflation expectations are well anchored. It’s like believing that the cobra has been broken up; he can now play to the tune of the snake charmer. Are you okay?

The inflation surge, in large part, could be due to supply disruptions from the second wave lockdowns and could gradually subside as conditions normalize as happened in the first wave in 2020. This can be the case. But the stakes are high: monetary and budgetary policies have been deployed to revive growth. The economy cannot afford to slow down. That aside, an inflationary explosion could strike political nerves. In recent months, the RBI Governor has suggested that the government should reduce taxes on petroleum products, edible oils, etc. to cool the prices. Yet, so restrictive are the revenue constraints that the government seems to bet on producers to absorb the increased costs of inputs. Are they going?

An important distinction is that unlike the first wave in 2020, we are in a different world in 2021. Many advanced economies are experiencing an inflationary surge after more than a decade, at least since the global financial crisis of 2008. The Economist Lawrence Summers has relentlessly urged caution in the face of overstimulation since US President Joe Biden decided on a $ 1.9 trillion Covid relief plan. Global financial markets have been nervous in recent months, but are holding up. Federal Reserve Chairman Jerome Powell believes, however, that the underlying inflation dynamic that has kept inflation low for a quarter of a century remains intact. Should we trust instinct?

Perhaps! Next door, China’s ex-factory prices jumped 9% in May, the highest in 12 years, as global commodity prices continued to rise after a six-year gap. To cool metal prices, nervous Chinese authorities recently decided to pull industrial metals out of their reserve stocks. Will the move be useful? We may not know until it’s actual execution. Two more of our BRICS partners, Brazil and Russia, have raised their policy rates three times in recent months to control inflation. The most disturbing development of all is the rise in the international price of crude oil, which is threateningly approaching $ 80 a barrel. Will this momentum be sustained? Difficult to trust any projection!

So what do these developments portend for the inflation outlook in India? What we do know for sure is that wholesale or producer prices have returned to the center of the economy after nearly a decade. India has not seen a double-digit WPI inflation rate since September 2011. The question is whether this will spill over into retail prices. ?
Some believe the transmission process is already underway, visible in the high core CPI inflation. But many also believe that transmission may remain incomplete due to demand constraint, especially for services. There is considerable merit in such a claim.

After all, most analysts, including RBI, have downgraded growth projections for this year, some with a downward bias. But there is a lingering doubt. What if the scars from Covid lockdowns had indeed eaten into the potential of the economy and the actual output gap was much smaller?

The surge in commodity prices is at a relatively early stage. It’s not known for sure if this will go bankrupt or turn into another super-cycle. There is little point in going over what happened during the UPA-II period. It was a true commodities super-cycle in which oil prices exceeded $ 140 per barrel in June 2008. Private sector demand was searing, aided and encouraged by accommodating fiscal and monetary policies, the economy overheating as growth exceeded its potential.

At present, although the budget deficit is much larger and monetary policy much more accommodating, economic growth remains below potential with very little private sector demand to support. Thus, from a macroeconomic point of view, the risks of a greater pass-through to retail prices appear to be low.

Does this mean that companies will have to absorb rising input costs, reducing their margins? This is not necessarily the case! It is well known that the ability of companies to pass on high costs also depends on the structure of the operating market. For example, the range is very low in a perfect competition configuration; in comparison, pricing power is multiplied several times in monopoly or oligopolistic structures. Over the past seven years, four major shocks – demonetization in 2016, rollout of the GST in 2017, NBFC crisis in 2018 and Covid-19 (March 2020 to May 2021) – have mainly damaged the informal sector, including many small ones. companies. However, these have helped large companies gain market share.

Many economists have preferred to see this through the prism of formalization, although there is no evidence of efficiency or productivity gains. But has the process left us with a more oligopolistic market structure?
What could constitute a cocktail is the design underlying the “Make-in-India”, viz. encourage domestic manufacturing with a protective wall of high tariffs and avoiding cheap Chinese imports. Many contact-based service companies also racked up overhead costs during Covid-19; they are also looking for opportunities to recover them. From an inflation perspective, these configurations present upside risks. If pent-up consumer demand suddenly spills over in the coming months, will companies stick to their prices?

It will be interesting to observe how the interaction between these macro and micro elements evolves. As much as we hope that the monsoon will hold the course.