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Inflation clouds gather

The recent past has seen inflation trajectory moving upward and it could go up further if food and fuel prices continue firming up, Skymet's prediction of deficient rainfall comes true, the new government opts for a populist Budget to spur demand and the rupee weakens below 70 against the dollar. If all these events happen at once it would trigger both demand-side and supply-side stress on inflation

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Inflation clouds are gathering over the economy as food and fuel prices go up.

With the prediction of a below-normal rainfall this season by the private weather forecaster Skymet, an expectation of a populist Budget by the new government and fears of the rupee tumbling to a rate of more than 70 against the dollar, retail inflation could well cross Reserve Bank of India's (RBI) target of 4%.

If these events play out simultaneously, they could trigger both demand-side and supply-side stress on inflation.

End of picnic

The two main factors that had beaten down inflation from over 7-8% to around 2% in NDA-1 were fuel and food prices. That reality may be different in NDA-2.

During NDA-1, the global crude prices had corrected from over $100 per barrel and stayed at an average price of $45-50 per barrel. That trend is now changing with Brent crude prices scaling up 39% from an average of $51.36 per barrel in December to $71.23 per barrel in April.

Even domestic food prices, which had remained in the negative zone for a long time, have lately turned positive. Food inflation has seen a sharp rise from -2.65% in December to 1.1% in April as the government tries to address the farm distress. This is a 3.75 percentage point jump in vegetable, fruits, milk, cereal and other food items prices in the last four months.

Indian currency touching 70 against the dollar in the recent past has also not helped much in pinning the inflation down.

These price pressures have been nudging up Consumer Price Index (CPI), or retail inflation, since February, when it rose to 2.57% from 1.97% in January. It further climbed up to 2.86% in March and 2.92% in April. Economists do not expect this uptrend to reverse any time soon. Most of them are projecting it to touch 4-5% in the current fiscal. RBI is targeting 4% retail inflation, with a tolerance margin of plus or minus 2%.

The Wholesale Price Index (WPI) inflation, which has a lower weightage of food (around 20%) and represents more the manufacturing goods, fuel and power (around 78% weightage), has also been heading upward from 2.76% in January to 2.93% in February and then to 3.18% in March. It eased a bit in April to 3.07%.

Gazing at inflation crystal ball

One of the major inflationary stresses is the developing El Nino conditions, which could result in lower crop production and further lift the food inflation.

Skymet has forecast below-normal rains at 93% of the long-period average (LPA). Rainfall at 90-95% of LPA is considered below normal. It is normal at 96-104% of LPA.

Mahesh Palawat, chief meteorologist of Skymet Weather Services, told DNA Money, "El Nino conditions are already present and will continue until the second half of July. Thereafter, it will start diminishing, but by the end of Monsoon chances are that 15% El Nino conditions will continue. So although rainfall will increase in the second half of July or other months, it will not make up for the deficiency of June."

D K Srivastava, chief policy advisor, EY India, estimated a rainfall deficiency of more than 10% would crimp agricultural output by one percentage point and push up the food inflation by 5-10 percentage points.

He sees CPI inflation coming in at 4% in the fourth quarter of the last fiscal and at 4.5% in the first quarter of the current fiscal. The EY economist, however, does not expect it to go beyond 5% this fiscal. "It would not be allowed to up beyond 5%".

According to him, inflation could also spiral up as the government tries to stimulate rural demand through farm income schemes such as Pradhan Mantri (PM) Kisan, which involves cash transfer into bank accounts of 12 crore farmer of Rs 6,000 per year at a cost of Rs 75,000 crore.

Bharatiya Janata Party's (BJP) manifesto talks about broadening this scheme by including 15% more farmers. This will push up the expenditure on it by Rs 20,000 crore.

Necessary evil

Srivastava also sees an upward revision in the Budgeted fiscal deficit target from the current 3.4% to 4% for fiscal 2020 due to erosion in tax buoyancy. He feels this could compel the government to go easy on inflation to improve tax collection.

"For some time we might need inflation closer to 5-5.5% so that tax revenue can pick up and fiscal deficit can be brought under control. With a lower rate of inflation, the fiscal deficit and tax revenues, in nominal terms, remain weak. I think moderate increase inflation might be good for the economy," said chief economist of EY.

Devendra Pant, chief economist and senior director (public finance), India Ratings and Research, gave a more conservative estimate. He expects CPI inflation to reach 4% by the third quarter of the current fiscal.

In its latest monetary policy review, RBI's outlook for inflation was 3.5-3.8% in the second half second of the current fiscal.

Contrary to Pant's prediction, the central bank has slashed its inflation projection for the first half of the fiscal to 2.9-3% from its earlier forecast of 3.2-3.4%. Also, RBI's review of the inflation trend does not see it coming closer to 4% before fiscal 2021.

The central bank has, however, attached caveats to its inflation forecast by putting out a warning on El Nino, which could take the inflation up by 50 basis points (bps). It has also red-flagged the upside risk of increasing international crude prices due to supply shortfall and geopolitical factor.

The India Ratings economist said while CPI inflation rising to 4% from 2.9% may not be a big concern, "authorities would have to be mindful of it".

Demand push

Madan Sabnavis, chief economist, CARE Ratings, said slowing demand growth in the last few months could have held down inflation a bit, but other factors are likely to push it above 3% soon.

In recent months, the economy has witnessed a weakening of demand in many sectors. This has seen core – non-food-non-fuel – inflation fall to 4.52% in April from 5.66% in December. It had shot up to 6.38% in June last year.

Typically, core inflation and demand growth move in the same trajectory. That is one of the reasons why even when retail inflation was easing in the past, the core inflation had remained firm. The gap between the two widened last year as headline retail inflation dropped 1.85 percentage points even as core inflation remained more or less stable. However, the recent softening in demand is expected to bring retail inflation closer to core inflation.

Madan sees the non-fuel-non-food inflation moving downward and stabilising in the region of 4-4.5% going forward. "All this would mean that the overall inflation number would definitely be above 3%, but I don't think at this particular time it will be moving above 4%," he said.

Government spend

He believes the new government is likely to drive up demand as they try to meet their poll promises and execute cash transfer benefits for farmers. This, he feels, could scorch the inflation more.

"There could be demand-pull inflation that could come in the picture, which was not there all these years, if the government spends the Rs 75,000 crore committed in the Interim Budget and goes for other such schemes," said the CARE economist.

Sabnavis said the supply-side inflation would depend on how the monsoon pans out.

Any jump in prices due to the government spending on social schemes is likely to prop up the WPI inflation, which gives more weightage to manufacturing goods, more than the CPI inflation.

"I wouldn't be exaggerating if I say that the Rs 75,000 crore spend (on farm income scheme) or higher fiscal deficit will push inflation up. So definitely the trend will get reversed if we keep taking manufactured goods inflation in the upper direction," he said.

The CARE economist's outlook for CPI inflation is around 4% for the current fiscal. His forecast assumes crude prices in the range of $70-75 per barrel and rupee depreciation of 3-4%.

India Ratings's Pant said crude at $70 per barrel was unlikely to have any significant impact on India's fiscal or inflation dynamics but above th0at it would be a matter of worry for the government.

"If they (global crude prices) move beyond $70 per barrel to around $75 per barrel or so and remain at that level for a longer period, then our fiscal deficit and inflation dynamics will be impacted," he said.

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