Interview: Elevated inflation here to stay, repo rate could be 5.5% by December, says HSBC’s Pranjul Bhandari

Q: What is your assessment on food inflation? Are edible oil and now wheat the only pain points? Is it more generalised?

A: I think the pressure is across the board. Agricultural input costs have gone up as well. In our last reading, agriculture input cost inflation was 15 percent year-on-year – that’s a pretty high number. So, this is the cost to plant new crops and when the harvest season comes, farmers increase the final prices to recoup that upfront expenditure made. And that’s why we may see a lot of the food price pressures in the months to come.

But I would not call it structural yet. I will say that India has seen high inflation even before global inflation picked up, but that high inflation was more led by core inflation and not as much by food. Remember when the RBI presented its policy in April, it was still sounding very positive on the food inflation outlook. But the commentary following the surprise hike in May was on the upcoming price pressures on the food side. So that is a key change in the story.

Q: A lot of inflation pressure is through commodity prices and their passthrough. Has the complete passthrough happened or will we see more increases?

A: Generally, the passthrough from producers to consumers is about 50-60 percent of input cost increases. So far, it is clear that the passthrough for goods manufacturers has been pretty strong. It’s the service providers who are not passing on as quickly and I think there is a reason.

Goods demand was a story of last year and a story that has run a good cycle. Goods producers have had the liberty to pass on rather than take it on their margins. Services demand story started this year because only by January a critical mass of Indians got vaccinated and started moving around.

So the growth in services demand is still playing out and I think my suspicion is that a lot of service providers are feeling a little uncomfortable about raising prices very quickly. So my sense is that so far goods inflation is far outpacing services. But eventually services inflation will catch up.

Q: We have had a very sticky core inflation in the past. Will this continue to cause discomfort?

A: I must say that India’s core inflation has been surprisingly high, even before global pressures picked up. Even in 2020, we had core inflation north of 6 percent and it has been a problem since then. There are very India-centric factors at play here. During the lockdown, small firms got disrupted and many had to shut shop or did not have buffers to withstand the long lockdown. These small informal firms were producers of necessary goods like clothes and food items, and there is a certain inelasticity of prices on these.

The other story is that big firms got bigger, they gained pricing power, and they began passing on price hikes. I think a combination of these two explains why core inflation was high even when GDP showed a double-digit contraction.

Now what we see is that manufacturers are facing commodity price shocks and they have to eventually pass these on to consumers. And that kind of freezes (core) inflation at a level.

Q: What will contribute to this stickiness?

A: Core inflation exhibits a huge amount of stickiness. I think that inflation is going to be sticky for three reasons. I think number one is the pricing power. Firms increase prices when commodity prices rise, but will they cut when prices fall? We will have to see.

The second is the fuel index. Some parts of the fuel index, like kerosene and diesel, are non-regulated and their prices have really gone up. But some other items such as electricity tariffs, have not. Electricity is a big part of the urban basket. Kerosene and biodiesel are a big part of the rural basket. This also explains why rural inflation is higher than urban. Discoms typically do not increase tariffs immediately, it takes 12-18 months to do that. So my sense is that the increase here will start kicking in one year down the line and that might be another source of sticky inflation.

A third source of sticky inflation is just the harvest cycles in agriculture. The whole cycle from sowing to harvest takes about six months. So the initial expenditure is recovered through prices only after some months, when the harvest is sold. And the producer would want to keep the price high, given the initial investment. This will make agricultural prices stay high for long.

Q: You have explained stickiness elaborately. So can we conclude that the easing of inflation is going to be a slow process?

A: If we think of 4 percent, I think it is going to take several years to get there. In my forecast, we can get to 6.8 percent this year. For the next year, headline inflation can go down to 5.5 percent. These are our forecasts and include both base effects as well as a slower economic growth in the second half of this year. But even 5.5 percent for me is a very high number.

Q: So what does this mean for monetary policy? Do you anticipate bigger hikes?

A: They have done the 40 basis point surprise hike and we expect another 40 bps in the June policy. But after that, we see a 25 bps hike trajectory and not a series of 40 bps.

Secondly, we think the RBI will have a couple of pitstops. So the first one would be 5.15 percent repo rate, which I think would be by September. This level was the pre-pandemic repo rate level. The second pitstop would be 5.5 percent and we think we will get there by December. This is an important pitstop because our one-year-ahead inflation forecast is 5.5 percent. At this point, we are out of negative real interest rates.

Beyond this, the hikes would be a function of what happens to growth to a large extent. If the RBI believes that the labour markets are at equilibrium and the economy is doing well, then they can take the real rates from neutral level to 1 percent. But we are not forecasting a 6.5 percent repo rate for that 1 percent real rate. What we think is that the RBI will go halfway, to 6 percent repo rate. This is the terminal repo rate I am looking at.

I also want to say that the stickiness of inflation does not necessarily mean aggressive RBI rate hikes. The reason is that there’s only so much the RBI can do when the source of the problem is supply side. They can only take care of the second-round effect and that also with a lag and with a side-effect of slowing growth. So at some point, we have to understand that the RBI has a fine balancing act to do.

Q: Do you see significant downside risks to growth, especially because of inflation?

A: For FY23, we have a GDP growth forecast of 6.8 percent, which is lower than the consensus. Currently, the pent-up services demand is playing out. We have not seen the export story get hurt so far. But these things can change. Our worry is that in the second half of the year, a couple of things will change.

One is that services demand would have run its course. Urban purchasing power will also come off a little bit in the second half of the year. The informal sector was doing pretty badly at the start of the pandemic in 2020 during the lockdown, then it recovered. Our sense is that ever since this commodity price shock has hit, the informal sector is again hurting and that could lead to repercussions.