Food prices must decline sharply to avoid interest rate hikes
Ever since the Urjit Patel
panel report was made public, the fear in the market has been that the
central bank will target inflation to the exclusion of everything else.
In a speech last Wednesday, governor Raghuram Rajan
allayed that fear by saying that the Reserve Bank of India (RBI) won’t
“administer shock therapy” to a weak economy. He has also turned on
those who say that the RBI is not doing enough by pointing to the
recession in the US when Federal Reserve chairman Paul Volcker rapidly
raised rates. In sum, Rajan has tried to give the impression that he is
steering a middle path, by choosing to target a slow and steady fall in
inflation, rather than go for the jugular.
This middle path is also the cornerstone of the Urjit Patel panel
suggestions—8% Consumer Price Index (CPI)-based inflation by January
2015, 6% by January 2016 and 4% (with a two percentage point band)
thereafter. The question is: by how much will RBI have to raise the repo
rate to reach those targets?
The answer depends a lot on the level of food and fuel
inflation, which are far from a pure monetary phenomenon in India,
points out an analysis by Credit Suisse.
Food and fuel prices have a 57% weight in the CPI. Therefore, for
overall CPI to reach the targeted levels, this component has to come
down, else it will require a dramatic fall in core (or non-food and
fuel) inflation, which in turn means that growth will have to be
severely curbed.
For the CPI to hit 6%, when food and fuel inflation
hovers around 10%, core inflation has to go down to 0.7%. That, as
Credit Suisse estimates show, will require a massive nine percentage
point increase in the policy rate, almost unimaginable. It will, of
course, wreck the economy.
Putting things in context, in January, retail inflation
for food was 9.9%, for fuel 6.5%, while headline consumer price
inflation was 8.8%. Core CPI (excluding food and fuel) was 8.1%. True,
food inflation had come down in January, but this is mainly a seasonal
phenomenon. This component has averaged 9% since 2005. And inflationary
expectations still remain high with 80% of respondents in the RBI survey
expecting double-digit inflation a year ahead. If growth starts to pick
up, it will mean additional pressure on core inflation unless the
supply side improves.
In any case, even if food and fuel inflation were to come
down sharply to 5%, Credit Suisse computes that a 90 basis point rise
in the repo rate will be needed for the CPI to come down to 6%. One
basis point is one-hundredth of a percentage point. That indicates the
odds are skewed in favour of rising policy rates in the next couple of
years, unless food and fuel inflation comes down drastically.
Ever since the Urjit Patel
panel report was made public, the fear in the market has been that the
central bank will target inflation to the exclusion of everything else.
In a speech last Wednesday, governor Raghuram Rajan
allayed that fear by saying that the Reserve Bank of India (RBI) won’t
“administer shock therapy” to a weak economy. He has also turned on
those who say that the RBI is not doing enough by pointing to the
recession in the US when Federal Reserve chairman Paul Volcker rapidly
raised rates. In sum, Rajan has tried to give the impression that he is
steering a middle path, by choosing to target a slow and steady fall in
inflation, rather than go for the jugular.
This middle path is also the cornerstone of the Urjit Patel panel
suggestions—8% Consumer Price Index (CPI)-based inflation by January
2015, 6% by January 2016 and 4% (with a two percentage point band)
thereafter. The question is: by how much will RBI have to raise the repo
rate to reach those targets?
The answer depends a lot on the level of food and fuel
inflation, which are far from a pure monetary phenomenon in India,
points out an analysis by Credit Suisse.
Food and fuel prices have a 57% weight in the CPI. Therefore, for
overall CPI to reach the targeted levels, this component has to come
down, else it will require a dramatic fall in core (or non-food and
fuel) inflation, which in turn means that growth will have to be
severely curbed.
For the CPI to hit 6%, when food and fuel inflation
hovers around 10%, core inflation has to go down to 0.7%. That, as
Credit Suisse estimates show, will require a massive nine percentage
point increase in the policy rate, almost unimaginable. It will, of
course, wreck the economy
Putting things in context, in January, retail inflation
for food was 9.9%, for fuel 6.5%, while headline consumer price
inflation was 8.8%. Core CPI (excluding food and fuel) was 8.1%. True,
food inflation had come down in January, but this is mainly a seasonal
phenomenon. This component has averaged 9% since 2005. And inflationary
expectations still remain high with 80% of respondents in the RBI survey
expecting double-digit inflation a year ahead. If growth starts to pick
up, it will mean additional pressure on core inflation unless the
supply side improves.
In any case, even if food and fuel inflation were to come
down sharply to 5%, Credit Suisse computes that a 90 basis point rise
in the repo rate will be needed for the CPI to come down to 6%. One
basis point is one-hundredth of a percentage point. That indicates the
odds are skewed in favour of rising policy rates in the next couple of
years, unless food and fuel inflation comes down drastically.
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