Why spike in headline inflation is unlikely to change interest rate trajectory

For one, there is the base effect. Last year in October food inflation was negative (-0.1percent) and thus the 7 percent increase in prices in October this year simply means that over two years prices have increased just over 3 percent a year. This is especially true in a category like pulses where prices are up 11 percent YoY in October this year but had fallen 10 percent in October last year, so over two years prices are essentially flat.

Secondly, food inflation is being driven by just three main categories currently. One is vegetables where prices are up 25 percent YoY. Second is pulses where prices are up 11 percent YoY. And third is meat and fish where prices are up 10 percent YoY. These three categories contribute just 25 percent of the food basket in the CPI. In the remaining 75 percent of the basket, inflation is below the aggregate food inflation. Indeed, in key categories such as cereals or milk or fruits, inflation is just around 3-4 percent.

Thirdly, there have been several weather-related disruptions this year to cause a short-term spike in food inflation – from several extreme weather events to unseasonal rains in October and even November to floods in several parts of the country. While some of these things are annual occurrences, this year, they have been unusual.

The bottom line is that there are enough reasons for the MPC to not worry too much about the recent uptick in food inflation. There is, however, one caveat and that is the state of the agri-price cycle. Agriculture prices in India are highly cyclical and as the chart below demonstrates have followed a remarkably consistent pattern over the past 50-60 years. And currently, we are close to where cycles have historically bottomed out.

So one of the things the MPC needs to monitor closely in the coming months is whether the recent uptick in inflation is transient and something they can ignore or whether it marks a reversal in the medium-term trajectory of food inflation which will eventually feed through to core inflation through wages. The stance of monetary policy will be very different based on whether it is the first scenario that is playing out or the latter.

Another point to note is that the 4 percent inflation target for the MPC is flexible. It is flexible in the sense that the achievement of the inflation mandate is not absolute. There is a secondary objective of growth that the MPC must keep in mind. It is subservient to the inflation mandate, but it exists. And it is flexible because there is a reasonably wide range of 2ppt around the 4 percent inflation target. It is only if inflation exceeds the outer band (of 6 percent) can the MPC be at risk of defaulting on its mandate. The appropriate monetary policy response when inflation is between 4 percent and 6 percent is a subjective assessment by the MPC (and hence by each of its members). So, it is quite conceivable that a particular MPC increases interest rates when inflation is at 5 percent whereas another MPC chooses to do nothing. Given that the composition of the current MPC has shifted towards being dovish after the resignation of Urjit Patel as well as Viral Acharya and also given the context of fairly weak economic growth, the current MPC is likely to be much more willing to tolerate above 4 percent (but below 6 percent) inflation. This is especially given that it looks as if at least some of the uptick in inflation could be transitory.

To conclude then, there is enough flux in the inflation data that given the deteriorating growth background and the flexible nature of the inflation mandate, the MPC can continue the path of monetary easing for now. It will, however, need to keep an eye out for signs that the recent uptick in food inflation is not transitory.