MC Analysis | MPC may face double whammy if Israel war escalates, heat wave wreaks havoc on food prices

The Reserve Bank of India’s (RBI) projection of 4.5 percent retail inflation in the fiscal year 2025 assumes a normal monsoon.

A surge in global crude oil prices in the event of an escalation in the Israel-Iran conflict, coupled with the impact of a possible heat wave across India that may trigger a spike in food inflation, could upset the inflation calculation of India’s rate-setting panel, according to experts.

The Reserve Bank of India’s (RBI) projection of 4.5 percent retail inflation in the fiscal year 2025 assumes a normal monsoon. Assuming a normal monsoon, CPI inflation for 2024-25 has been projected at 4.5 percent with the first quarter at 4.9 percent, the second quarter at 3.8 percent, the third quarter at 4.6 percent and the fourth quarter at 4.5 percent. The Indian Meteorological Department (IMD) on Monday forecast an above-normal monsoon.But there are two significant fresh upside risks to these assumptions now--a possible surge in global crude prices if the Iran-Israel conflict escalates and a potential food inflation spike from the impact of heatwaves in the next two months, something also predicted by IMD.

Analysts estimate crude prices may spike to $100 a barrel if supply chains are disrupted.

Iran-Israel conflict impact:

Since the Iran attack on Israel, crude oil prices have risen by 1 percent to around $90.55 a barrel on account of what could be the biggest escalation of Middle East tensions since the start of the Israel-Hamas war in October 2023.The increase was driven by concerns over potential supply disruptions.

At the time of publication of this article, Brent crude was trading at $90.55 a barrel, while US West Texas Intermediate crude rose to $85.66, posting a weekly loss due to a bearish world oil demand growth forecast from the International Energy Agency (IEA) and worries about slower US interest rate cuts. Israel is reportedly planning a counter-attack to Iran’s recent military action. This will have ramifications on India’s inflation as the country is one of the biggest importers of crude in the world. Hence, a rise in global prices can have cascading effects on local price trends.

“The impact will depend on how crude oil prices react. Sensitivity analysis indicates that a 10% increase in crude oil prices can increase headline inflation by 30bps. However actual impact will depend on if retail petrol diesel prices are increased,” said Gaura Sengupta, Economist, IDFC First Bank.

India’s retail inflation rate eased to a 10-month low of 4.85 percent in the previous month, according to data released by the Ministry of Statistics and Programme Implementation on April 12. The Consumer Price Index (CPI) inflation print in February was 5.09 percent. At 4.85 percent, the latest headline retail inflation figure is the lowest since May 2023, when it came in at 4.31 percent.

On April 5, the Monetary Policy Committee (MPC) chose to retain the key rates unchanged, citing the unfinished battle against inflation. The rate-setting panel reiterated its determination to align retail inflation closer to the four percent medium-term target. Announcing the policy review, RBI Governor Shaktikanta Das said the recent uptick in crude oil prices needs to be closely monitored. “Continuing geopolitical tensions also pose an upside risk to commodity prices and supply chains,” Das added.

A tough battle:

The MPC has a 2 percent to 6 percent inflation band to work with, but the medium-term target is 4 percent.

While CPI inflation has extended its stay within the RBI’s tolerance range of 2 percent to 6 percent for a seventh consecutive month, it has now spent 54 months in a row above the medium-term target of 4 percent.

“There continues to be uncertainty over the current geopolitical tensions. A further escalation in the Iran-Israel conflict that leads to supply disruptions could pose a risk for domestic inflation. A move in oil prices towards $100 per barrel could raise inflation by 20-30bps,” said Sakshi Gupta, an economist at HDFC Bank.

Heatwave threat:

Geopolitical tensions apart, the monsoon situation remains tricky. On April 15, the IMD said India is likely to receive above average monsoon rains in 2024, which, if it happens, will be a big boost for the country that depends heavily on the summer rains for its farm production. However, the IMD has also predicted extreme heat from April to June, with the central and western peninsular parts expected to bear the brunt. This could have major ramifications on production and supply chains, further impacting the inflation projections.

Further, depleting water levels have a spillover impact across different aspects of the economy. Water levels at India’s 150 major reservoirs are down to 35 percent of live storage capacity; according to the data from the Central Water Commission, The available water as of the first week of April was 61.801 billion cubic metres, 17 percent lower than the corresponding period last year. The situation is direr in the south, with the 42 reservoirs in the zone at 23 per cent capacity.

According to Madan Sabnavis, chief economist of Bank of Baroda, lower water reservoir levels impact access to drinking water and farming activity. “Heatwaves impact fodder cultivation, horticulture, and vegetable prices. This could also be inflationary with ramifications for the monetary policy.”

The threat of food inflation:

Heat waves can have an extremely significant impact on price trends, considering that food inflation is a major villain in the whole inflation story.

Food inflation has a major weight in overall inflation. Food has an overall weightage of roughly 25 per cent in the WPI basket, while in the CPI basket, food accounts for a weightage of 46 per cent.

Rating agency ICRA estimates the food and beverages inflation to remain above the 7.0 percent mark in April 2024. “An intensification of the impending heatwave may worsen the seasonal uptick in prices of perishables, heightening the criticality of a favourable monsoon in 2024 to keep food inflation in check and inflationary expectations well-anchored,” according to Aditi Nayar, Chief Economist, ICRA Ltd.In the monetary policy statement, the RBI Governor highlighted the threat of high food inflation to MPC’s inflation management.

“Food inflation continues to exhibit considerable volatility impeding the ongoing disinflation process. High and persistent food inflation could unhinge anchoring of inflation expectations which is underway,” Das said.The MPC hiked the key policy rate, repo by 250 basis points to fight high inflation between May 2022 and February 2023. The monetary tightening has paid off in bringing down inflation to within the 2percent to 6 percent target but reaching the 4 percent medium term target has remained elusive until now.