India’s growth outlook has been whacked thrice in less than two years. Two waves of the Coronavirus have crippled economic conditions, which were already weakened by a slowdown to 4 percent real GDP growth even before the pandemic arrived.
The triple whammy has pushed back demand to levels at least three years ago. Poor aggregate demand is pressurising producers to absorb the relentless price growth of all inputs, from oil to metals and other raw materials. They are hard pressed to not transmit the shock to consumers, i.e. raise retail prices. That would dent sales, depress consumption, leaving little choice but to accept a squeeze on their margins. Divergent movements in producer and consumer prices hint at decline in firms’ profits ahead. But the continuous ebullience of stock prices suggests little concern. Could there be a sharp correction when reality dawns?
In May, headline and core producer (WPI) inflation accelerated by a respective 13 percent and 10 percent; the sequential momentum (month-on-month, three monthly averages) in core producer price growth is unabated for last three quarters. The source is a global rally in fuel and commodity prices. At the retail level, however, headline inflation trended in the reverse direction in October-April, until the data released on June 14 showed a 207 basis point monthly jump in May to 6.3 percent.
However, last month’s across-the-board increase in food, fuel and core components of CPI inflation is difficult to interpret: the imputed base last year was treated a break in the series by the RBI, the cost pass through may be one-time, it is yet not clear the rise in core CPI inflation (excluding fuel, food) to 6.7 percent (April 5.3 percent) represents demand pressures, and if the rise is transitory.
The gap in headline producer and consumer price inflation widened extraordinarily in March-May 2021 — 427 basis points in three months. In April and May, the divergence shot up to more than 6 percentage points! The widening differential vis-a-vis CPI inflation indicates weak demand conditions are tempering transmission. A similar trend is being observed in China, where the producer prices rose 9 percent last month due to the rapid growth in the global prices of commodities. But the higher costs of raw materials have not reflected in consumer price movements, which rose an annual 1.3 percent but declined month-on-month; core retail inflation was subdued at 0.9 percent as producers absorbed the raised costs.
Markets are forward-looking. They incorporate current information to anticipate the future and accordingly adjust. Perhaps they should anticipate an impending decline in corporate profits from the disparate price trends observed at the producer and consumer ends, and what might these signify. But there’s no sign of this so far. The Sensex, for example, has risen at least 8 percent since the middle of May. No doubt the robustness of corporate profits in the last quarter and GST collections, among others, are sound reasons for the jubilation. But all that is past. What’s important is that the rosy profits may be unsustainable according to the logic of real variable behaviours, i.e. producer and consumer price movements in this instance. An abrupt adjustment could follow if this belief takes hold.
The possibility of a sudden sharp correction is a risk the RBI needs to watch out for. It will have to be particularly careful in its liquidity management. Currently, and in favour of growth, the central bank is engaged in heavy buying of foreign currency and bonds; active in both markets, it is determined to keep either asset price where it wants it to be.
Surplus liquidity has long abounded. So far, the risk of it spilling on to inflation has been relatively absent given the lack of credit demand — base money growth hasn’t resulted in money supply pacing faster and its translation into credit growth. A general sanguineness has prevailed that an outsized output gap or weak demand is tempering inflation risk.
There can, however, be symptoms other than inflation that could develop. Excess liquidity, for example, could find its way elsewhere. With few assets fetching good returns, rising stock prices are an attractive avenue for its deployment. An abrupt, steep correction in the equity market is then a risk to watch out for. The current environment of business resumption, return of suppressed demand, vaccine optimism and positive global impetus may be overwhelming risky signals emitted in other quarters. But these could outweigh all others at some point.
The central bank should be alert to such fallout. Of course, if producer price inflation does indeed transform into generalised inflation at the retail level, it would be quite another and sorrier story for the whole economy.
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