Inflation, Growth, Recovery | It is a bit early to celebrate

Representative image.

Things have taken a sudden positive turn. Foreign portfolio investors have returned to Indian markets, giving the Reserve Bank of India (RBI), which until recently was battling exchange rate pressures and expending reserves, a much-needed breather.

Then, new data in the past fortnight show inflation maintained its moderation trend in July, the third successive month. Many lead indicators demonstrate strengthening economic activity too. Overall, this is a budding configuration loved by central bankers and governments. But inflation is still too high, and the recovery weak and uneven. The question is if price stability will continue to restore and growth gather force in forthcoming months?

The positive turnaround, which accompanies an unexpected 50-bps policy rate hike on August 5 by a hawkish-sounding central bank, has sparked optimism. This is brimming with prospects of further economic improvement as service activities gain more momentum, the good rains and festive season round the corner. Not many are worried if inflationary risks could resurge, or demand recovery remain weak or get restricted by the rising cost of funds that could get pricier ahead. In the tricky environment of uncertainty about the US’ tightening cycle, slowing of the world economy, volatile commodity prices, and discernible domestic weakness, it may be a bit early to celebrate the sudden reversal however. Several signs point to caution.

The fall in retail headline inflation, for example, owes much to the easing of vegetable, edible oil, gold-silver, and energy prices that are inherently not so stable. Two, core retail inflation is stubborn around 6 percent, much too high and strengthening over June, and without its volatile constituents (fuel, gold, silver), rising last month. It signifies that demand stays firm. Cereal price movements cast a tentative shadow on the outlook: wheat prices have accelerated in the last two months; wholesale price of wheat jumped to 14 percent in July from 10 percent rise in June; and an output shortfall with lowered buffer stocks suggesting little space for price management by the government. A nascent pick-up in rice prices looks set to increase because of ~13 percent lower acreage sowed until now.

Readings from lead economic indicators are similarly not without reservations. The most accurate gauge in inflationary times is the volume-based measure of industrial output. Its first-quarter growth (April-June) is best interpreted on sequential basis because of statistical aberrations in corresponding quarters of previous two years. This shows manufacturing and general industrial output growth (three-month moving average of m-o-m growth) has not steadied so far, being positive only in May. A more appropriate comparison with the pre-pandemic quarter, April-June 2019, shows overall industrial production grew 4.8 percent, and manufacturing 3 percent; the bulk came from electricity (15.3 percent).

The economic story told by the use-based industry indices is more disappointing. Consumer goods’ output, durables and non-durables, contracted -8.2 percent and -1.1 percent respectively over pre-pandemic levels (FY20:Q1), growing positively only in June (3.3 percent and 5.7 percent). This warrants watchfulness for sustenance. Capital goods’ output fared no better in the quarter at -4.8 percent over pre-pandemic level, again with a small positive upturn in June (0.5 percent). The production bang in the quarter has been solely due to infrastructure and related segments. Buttressing signs are visible from bank credit movements, where real industrial credit (adjusted with core WPI-inflation) growth averaged -1.7 percent y-o-y in April-June 2022, and 2.7 percent higher than FY20:Q1.

From the standpoint of recovering aggregate demand therefore, consumption and investment are considerably depressed, barely raising their head over pre-pandemic level in June. The uplift in private consumer and business spending is dismally weak; dependence upon government expenditure considerable. Real services and personal loan are growing far stronger though. Pitted against the consumer goods production, especially of non-durables, does that reflect unequal demand recovery? Consider that real rural wages contracted the last two years and into the just-concluded quarter; in conjunction with the subdued sales of two-wheelers and entry-level cars versus those of large and luxury cars, the picture isn’t at all rosy. Inflation is eating into incomes and purchasing power, dragging down total demand.

Finally, the return of portfolio capital inflows reassures external financing and alleviates exchange rate pressures. This comes at a time when exports have slowed and anticipated to turn down further ahead — initially from inventory destocking, demand rotation and inflation, followed by deepening spread of the synchronised slowing in China and other advanced economies.

It’s pertinent to flag that common global factors propel foreign investors back to emerging markets of which India is a part; they are less drawn by country-specific reasons. Market beliefs that the high interest rate regime will not persist, or that the US central bank will be able to reign-in inflation without foregoing output or very little of it, etc. may be mistaken. Fickle foundations of such capital mean it can take sudden flight if actual outcomes are contrary. The environment is anything but smooth, especially for India, a net commodity importer, and whose currency bears the brunt of financial adjustments or depreciation.

The sudden improvement could as suddenly reverse in such thorny settings.

Renu Kohli is a New Delhi-based macroeconomist. Views are personal, and do not represent the stand of this publication.