Inflation is down – but RBI remains vigilant

The Monetary Policy Committee of the Reserve Bank of India (RBI) has preferred to stand put than surprise the way it did in April. That is par for the course. The inflation print for the last two months seems to indicate that the peak has been passed: The wholesale price index (WPI) inflation fell to -0.9 per cent in April from 1.3 per cent in March, while the consumer price index (CPI) inflation declined to 4.7 per cent from 5.7 per cent. We expect the pause to continue through 2023.

The RBI has communicated that its fight against inflation is not over till it is aligned with its target of 4 per cent on a durable basis. This implies it will not be in a hurry to cut rates. We foresee a rate cut only in January-March 2024.

While a likely end of the rate hike cycle in advanced countries over the next couple of months will help, softening domestic inflation is swaying Mint Road. Additionally, the withdrawal of Rs 2,000 bank notes, 50 per cent of which have been returned, is expected to inject liquidity into the system.

Meanwhile in the US, tightening financial conditions, amid the banking stress, helped the Federal Reserve (Fed) by creating a downside to growth and inflation. The enduring gap between Fed’s communication and market expectation is narrowing and the markets now see the Fed funds rate at around 5 per cent at the end of the year compared with below 4 per cent a couple of months back. Fed’s mid-June rate decision will be a close call. That said, a “higher for longer” scenario looks more likely in the US, given above target inflation and the strength of economic activity there.

In Europe, however, core inflation has been quite sticky, and the European Central Bank is likely to continue raising rates. Interestingly, the Bank of Canada and the Reserve Bank of Australia raised interest rates in June. On the other hand, most emerging markets have seen the peak of the rate hiking cycle.

In India, a sharper-than-anticipated decline in inflation in March and April was driven by base effect and a correction in commodity prices, which had spiked due to the Russia-Ukraine conflict last year, creating a favourable statistical base effect. Although the favourable base effect will fade over the next few months, we expect consumer inflation to average 5 per cent this fiscal as compared to 6.7 per cent last fiscal.

Normal monsoons are important for a durable decline in cereal inflation, which is currently in double digits and has a high weight in consumer prices. In May, the India Meteorological Department reiterated its normal monsoon forecast. So, assuming a normal monsoon, we expect food inflation to soften.

That said, what matters for agriculture and food inflation is not just the amount of rainfall, but also its distribution over time and geography. Clarity on this aspect will emerge with the progress of the monsoon.

It would be the fifth successive normal monsoon — if it does turn out to be one. That is a rarity. With climate change at play, monsoons can always throw a curveball. Plus, the Australian Bureau of Meteorology recently elevated the El Nino watch to the “alert” category, indicating a 70 per cent chance of El Nino this year. Fingers crossed, therefore.

Fuel inflation is already heading down and will come down further as global crude prices will be lower compared with last fiscal. We expect the per-barrel brent price at $80-85 this fiscal year compared to $95 in the previous one.

Core inflation, obtained by excluding fuel and food from the overall CPI basket, has been the sticker part of inflation, not only in the last fiscal but also in the past. Slowing domestic demand and lower input prices will help tame it a bit.

Another interesting feature of inflation dynamics is the goods versus services inflation. Goods inflation has corrected more than services inflation. Historically, service inflation has been higher than goods inflation. During the pandemic, due to reduced demand for services, its inflation stayed lower than goods inflation, which had spiked due to the supply shock amid continued demand for manufacturing products. That is correcting.

Demand for services such as airlines and hospitality has turned fast and furious with the withdrawal of Covid-induced restrictions and this is pushing up their prices. Concomitantly, the correction of commodity prices has dragged WPI into deflation territory and will help soften consumer price inflation with a lag.

For 2023-24, RBI has maintained its growth forecast of 6.5 per cent and cut its inflation forecast. Growth for 2022-23 was revised up by the National Statistical Office recently to 7.2 per cent from 7 per cent. The momentum for the first quarter of the current fiscal so far is quite healthy, as expected by the RBI, which has forecast a 8 per cent growth for the quarter.

As per S&P Global’s Purchasing Manager Index (PMI), both manufacturing and services remained robust in the first two months of this quarter. Between April and May, the manufacturing PMI rose from 57.2 to 58.7, while for services, it was above 60 in both months.

The numbers for 2022-23 show consumption and investment activity were quite robust, outpacing overall GDP growth. While investment remained strong for all four quarters of last year, private consumption slowed down towards the second half. We expect investment momentum to continue this fiscal and private consumption to be a tad slower compared to last year.

On the whole, we expect growth to slow to 6 per cent this fiscal as global economic activity decelerates in the second half of 2023 — after a better-than-anticipated showing in the past few months — and the lagged impact repo rate hikes show up. Consequently, merchandise exports, which have been already slipping, will decline more as growth in the West, India’s major export market, unravels. On the other hand, China is growing but that does not help much — they account for less than 5 per cent of our total exports.

Housing and auto loans have already risen past pre-pandemic levels and given that some transmission of the rate hikes is yet to play out, activity would moderate down the road. With consumer inflation in the first quarter set to print lower than its forecast of 5.1 per cent, there is little surprise the RBI cut the inflation forecast to 5.1 per cent from 5.2 per cent for the full fiscal. As for agriculture output and prices, the eyes are riveted on the monsoon.

The writer is Chief Economist, CRISIL