RBI faces a core challenge in its journey to drive inflation below 6%

Food as always been the biggest determinant for India’s retail inflation trajectory for its sizeable weightage in the consumer price index (CPI). Historical triumphs and trounces for the Reserve Bank of India (RBI) on the inflation front have largely been driven by food. But any central bank worth its salt would not ignore the part where it can directly make a difference: the core inflation.

Core inflation excludes the food and fuel prices and captures the underlying demand conditions in the economy, something that is effectively influenced by the monetary policy.

The Covid-induced lockdowns of 2020 had debilitated demand which pushed core inflation away from the policy discourse. After all, it was not a threat amid a sharp contraction in the economy in FY21 and the slow recovery that followed. The core inflation averaged around 5.50 percent during FY21, the year that was ravaged by the pandemic.

In short, despite the temporary blow to demand, the prices of goods and services have managed to remain elevated. But policymakers rationalised that this is largely supply-driven and monetary policy cannot do much about it.

Irrespective of the cause, a stronger core inflation is uncomfortable for the RBI. The chart shows how core inflation can come back to bother. Core has climbed and remained above 6 percent for more than a year now and it could make the RBI work harder to bring headline retail inflation into the mandated 2-6 percent band even if other factors such as base effect and ease in global commodity prices drag it down.

The Sticky Floor 

Even over a longer period of a decade, core inflation has sustained around 5 percent and above despite periods of economic slowdown. Therefore, it is the stickiest part of retail inflation and thwarts the fall of headline inflation below a certain level.

The inflation moderation period during 2014-2016 was marked by a steep fall in food inflation. True, softening demand has kept core inflation subdued up until 2020 but didn’t cause a sustained fall in it.

Economists are now flagging the sticky core as a concern. “With moderating input cost pressures on goods, but reopening effects on services and higher cereal price inflation, we expect headline inflation to remain above 6 percent until February 2023, and core CPI inflation to remain sticky at a shade under 6 percent in the remaining months of FY23,” economists at Nomura wrote in a report.

One of the reasons for core inflation to sustain is Indian companies have been able to pass on the cost pressure even during the worst slowdown, mostly due to market inefficiencies. The pandemic has only made these inefficiencies stark.

“If you believe that K-shaped recovery post the pandemic, you would see that the upper part of the K is leading the supply of the key goods and services. So, pricing power is sustained and will only get stronger even if demand is not what it was before,” said the chief economist at a foreign bank, requesting anonymity.

Economists at HSBC India point out that pricing power at large firms would keep the core inflation elevated.

Add the fact that services inflation continues to stay elevated as Indians doubled down on discretionary expenses in the past months with the receding of the pandemic.

Policy Implications

For FY23, the RBI is unlikely to be able to tame inflation below 6 percent. It expects the headline inflation to be 6.7 percent by March and ease thereafter. The softening in global commodity prices in the recent months has improved the outlook on inflation but not enough for economists to pare down their forecasts. That is because a depreciating currency will likely offset any benefits that arise out of the easing input costs.

The RBI too has remained cautious and retained its inflation forecast for FY23 at 6.7 percent. In fact, it expects inflation to ease to 5 percent in the first quarter of FY24 mostly because of the base effect. The upshot is that the central bank cannot take its foot from the rate hike pedal.

Most economists expect two more rate hikes by December. By then, the effects of past rate hikes would be visible and a clear picture on global commodity prices may emerge. That said, the rate hikes won’t dent core inflation so soon. To curb core inflation, measures beyond rate hikes could be needed.

“Steps to lower core inflation may require not just more upfront rate hikes (we expect two more rate hikes, taking the repo rate to 6 percent by end-2022), but also reforms that lower inefficiencies in factor markets such as land and labour,” HSBC said in a report.

The impact of the pandemic was asymmetrical on the economy with small firms suffering the most while large listed companies weathered the impact. The recovery made the difference between small and big firms and between different sectors of the economy stark. The skewed earnings growth among listed firms shows that pricing power rests with a few large firms. Policymakers would need to be careful in ignoring the implications of this on prices while focusing too much on the damaged balance sheets.