There was a sense of cheer when the CPI inflation fell from 7.61% in Oct-20 to 6.93% in Nov-20. However, Dec-20 CPI inflation at 4.59% was lower than the most optimistic estimates. In a survey of economists by Reuters, the most optimistic estimate of inflation for Dec-20 was pegged at 5.28%. The Dec-20 inflation has bettered even that by almost 70 bps. The question is whether the fall is sustainable. That is something we will know in the next few months. The good news is; CPI has fallen to the RBI long-term median inflation target of 4%.
Dec-20 inflation at 4.59% is not only the lowest in the last one year but it represents a 302 bps fall in just two months. The bumper Kharif output is finally beginning to have its impact. Of course food inflation has fallen almost vertically and that is what led CPI inflation lower, but we shall look at that in more detail later.
One interesting observation in Dec-20 inflation is that there has been a sharp fall in rural and urban inflation. If you look at overall urban inflation it is down to 5.19% in Dec-20 compared to 6.73% in Nov-20. The fall in rural inflation is much sharper. It has fallen from 7.20% in Nov-20 to a low of 4.07% in Dec-20. In both rural and urban centres, the trigger for the fall in inflation was food inflation. Urban food inflation fell from 9.23% to 4.08% while rural food inflation fell from 9.64% in Nov-20 to 3.11% in Dec-20.
Core inflation remains a problem area
Contrary to market expectations, core inflation did not correct in tandem with food inflation. Core inflation for Dec-20 stayed around 5.65%; a marginal fall from 5.79% in the previous month. Since May 2020, the core inflation has remained above 5%. Normally, core inflation level of below 4% is considered ideal to sustain overall inflation target of 4%.
In the case of food inflation, it was almost the reversal of an anomaly. Last year, despite a bumper Kharif and Rabi output, food inflation in Dec-19 had touched a peak of 14.12%. Over the last one year, the supply shortfalls in the market have been largely addressed and that has brought the food inflation all the way down to 3.41%. However, food inflation tends to be cyclical and the government has the ability to control food inflation in the medium run; if not in the very short run. But, policy measures appear to have worked here.
The real worry is core inflation. Now, core inflation represents that portion of CPI inflation excluding food and fuel. Core inflation represents a lot of secondary demand and the real issue is not about too much demand but supply shortfalls. That is much harder for the government to resolve, which is why core inflation tends to play a more decisive role in overall sustainable inflation in the medium term.
How did food inflation drop so sharply in Dec-20?
The sharp fall is partially due to tempering of food prices, partially due to better supply flows and partially due to the base effect. Hence a consistent trend over the next 2-3 months would be more conclusive. Here is what led food inflation lower in Dec-20.
What does CPI inflation mean for RBI stance?
Meat and fish inflation in Dec-20 was lower on a sequential basis at 15.21%. Egg Inflation has tapered by over 400 bps since Nov-20. However, it is still about 50% higher than the levels of 10.11% seen in Aug-20.
Fruit inflation has picked up in Dec-20 to 2.68% compared to just 0.27% in Nov-20. The real impact was visible on vegetable inflation which fell from 22.51% in Oct-20 to 15.63% in Nov-20 and down to (-10.41%) in Dec-20. That had a huge impact on the food basket.
Pulses inflation tapered to 15.98% in Dec-20 compared to 17.91% in Nov-20 and 18.34% in Oct-20. Cereals inflation fell sharply to 0.98% in Dec-20 from 2.32% in Nov-20 and 3.39% in Oct-20. Sugar inflation was also lower at 0.58%
If you sum up the food basket, it has a weightage of 45.86% in the CPI inflation basket. Cereals, milk, vegetable and snacks constitute 61% of the food basket weight. All these 4 items have seen inflation tepid, so to that extent, the sharp fall in CPI inflation in Dec-20 may really not sustain, if this matrix breaks down.
In the last 2 monetary policies, it is quite clear that inflation ceased to be a critical factor in deciding monetary policy outcomes. Even assuming that inflation is down, the RBI has very limited leeway to cut repo rates further, considering that rates are already at 25-year lows. At best, lower inflation may be instrumental in helping the RBI MPC justify its low repo rates and ensure that the influx of FPI flows continues. That is good enough!