Domestic concerns with respect to rising CPI inflation have been escalating lately. Prima facie these are well founded since, largely owing to an adverse food price shock, the headline CPI is likely to be well above the RBI’s latest projections for Q3 and Q4 (5.1% and 4.7% respectively). While most of these pressures are owing to vegetable prices, there is also evidence of some more generalized food price rise (notably in pulses). Also while vegetables are perishables and therefore are prone to displaying more widespread two-way volatility in prices, supply responses on items like pulses may take longer and hence the price rise may be stickier.
It is largely these pressures that seem to have weighed on the assessment by the Monetary Policy Committee (MPC) in the previous policy where it, against consensus expectations, decided to keep rates on hold. However, and to his credit, the Governor has kept the door for future cuts wide open thereby keeping the consistency amongst guidance, liquidity, and policy rates alive for now. However, market participants are increasingly getting more edgy. To the extent that information can be gleaned from market curves, the overnight indexed swap (OIS) curve has now fully unwound any further future rate cuts and is increasingly getting tempted to start pricing a very modest hike down the line.
Let’s All Calm Down
It is remarkable how the narrative has shifted from worrying about very low nominal growth (nominal GVA printed 6.3% for the September quarter and the official full year forecast is 7.6%; a multi-decade low), to now worrying about inflation. Right away it is evident that we can’t worry about both problems simultaneously, at least not from the standpoint of any practical policy construct. As far as we are concerned, the problem is still of growth. The economy is probably growing around 150 bps below potential growth rate at this point. By definition then, a generalized demand inflation (something that policy can address) is not the problem at all. Specifically, it is unlikely that there are second round effects of a supply shock induced price rise via translation into generalized wage increases and hence higher aggregate demand. And this channel is all that should ultimately matter to MPC, even as it may optically decide to not ease policy while a supply shock induced price rise is underway.
Source: CEIC
Note: Real wage is nominal wage deflated by CPI-rural
The chart above tracks the growth in rural wages up to October 2019 (both nominal and real). The first takeaway is that the growth rate of nominal rural wages has been actually dropping over the past few months even as rural CPI has been rising. Thus there seems to be little evidence of any sort of generalization yet. Further, and because of this recent trend, real rural wage growth has actually collapsed and has in fact turned negative. This seems to confirm the point that, in a weak growth environment, supply side shocks actually produce a net incremental deflationary effect via demand destruction. Of course, if the price rise were to persist then wages could get an upward lift with a lag.
The other aspect to weigh here is that, the benefit of higher prices may have accrued to the owner/ farmer and the intermediary (trader) which aren’t captured in the above graph. But if this is a mere transfer of income from the wage earner to entities “upstream” or “downstream”, then again there is no net positive impact on aggregate demand. Also if by definition the price spike is owing to a supply shock, then quantity produced has been affected. Therefore the total realization may not have increased by the same magnitude as the price rise. Indeed depending on the severity of the quantity depletion, it may well have been the same or fallen.
Takeaways
There is an optical problem with our near few CPI prints. It may be understandable then for monetary policy to take a pause and assess. However, if the above analysis rings true, there is little here for policy to change direction on; especially as the current phase for India looks to be much more than just a mid-cycle slowdown. To us the biggest practical indicator of actual growth versus potential is the current account deficit (the savings-investments balance). This continues to support a view that we are probably much below trend. Thus policy cannot lose sight of the continued need for counter-cyclicality depending on where the most space and efficacy lies. Also, by definition, counter-cyclical policies are just that and aren’t either substitutes or rivals for medium term structural reforms.
To us the near term problem for India is the unwillingness of risk capital to participate meaningfully in either market risk (sovereign bonds) or credit risk (including in lending). Policy in both markets has to have predictability and incentivize risk capital to become higher involvement in order, overtime, to influence both term and credit spreads and hence speed up transmission. Even as lending rates may be determined by shorter term cost of money, basic risk principles dictate that there should be some risk-free rate plus pricing for long term lending as well. For that reason, the stickiness of sovereign yields is also a key aspect of the problem of transmission today.
Apart from the near problem, the sequencing of the next growth impetus has to ensure sustained financing first. In the first go the additional ask can be met via offshore capital. This can be done but requires a clear road-map and execution plan for inviting such capital into various aspects of our financing requirements (real economy projects, disinvestment, stressed assets, government bonds). Overtime, though, domestic savings need to be pulled up or else the future sustaining of our investment ambitions may be thwarted by the width of our current account deficit then and a crowding out in the local markets.
The Disclousers
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