The strong positive linkage between food inflation and CPI inflation is quite evident from the correlation figure of 0.985. This is largely explained by the fact that food basket accounts for 39% of the overall CPI basket. Also, food prices tend to be the most volatile among the various CPI baskets and hence food inflation has an inordinate influence on retail inflation overall.
How inflation panned out in March 2020
As can be seen in chart, the sharp fall in CPI inflation finally breaks the trend of rising inflation. That had been the big worry for the RBI as it had already cut repo rates by 75 basis points in late March in the light of the COVID-19 pandemic. The idea was to neutralize the likely impact of the lockdown. Between Jul-19 and Jan-20 the CPI inflation had rallied from 3.15% to 7.59%. With two consecutive months of price fall, the trend in inflation appears to have been arrested. While the more enticing explanation for the fall in inflation appears to be the bumper Rabi crop, the alternative view is that the fall in inflation could have been driven by slowdown in demand. We shall come back to this point later.
The encouraging trend is rural inflation. Last year, the pressure of a rural slowdown was visible in weak rural inflation. However, that appears to have changed with the bumper Rabi crop and the helicopter money policy of the government boosting rural demand. The trend is most pronounced in the case of the food basket where the rural food inflation has moved from negative territory to 8.88% on a YOY basis.
In a nutshell, it was all about food inflation
If you see the strong correlation of 0.985 between food inflation and overall CPI inflation, it is clear why food has driven the fall in overall inflation. For example, between Jan-20 and Mar-20, overall inflation fell from 7.59% to 5.91%. This was triggered by a sharp fall in food inflation from 13.63% to 8.76%. So, what exactly has driven this sharp fall in food inflation?
The big drop in the food basket inflation is seen in fruits, vegetables and pulses. The focus of the government in expanding the supply of onions through imports and fine tuning the supply chain has surely helped bringing vegetable inflation under control. One can argue that vegetable inflation and pulses inflation at above 15% are still too high, but on a relative basis they are sharply down. Also, the CPI inflation in March 2019 was just 2.86% so the base effect has actually overstated the inflation in March 2020. As the base moves higher, the food inflation should get tempered a lot more.
Will inflation have an impact on repo rate trajectory?
Normally, lower inflation is considered to be conducive to lower repo rates. But then we live in abnormal times and the normal metrics may not really work. When the Monetary Policy Committee met in an emergency session on March 27th and announced a 75 basis points cut in repo rates, inflation was the last thing in their minds. The only issue concerning them was how to reduce the macroeconomic damage of COVID-19 and how to ensure the lockdown does not result in structural damage to the economy. To that extent, the rate cut on March 27th had little to with inflation and was entirely to keep the Indian monetary policy in sync with global policy stand. Over the next 2-3 quarters, as long as the overhang of the COVID-190 remains on the Indian economy, the rate of inflation is unlikely to impact monetary policy rates in any significant manner.
Real risks to inflation could come from the lockdown?
A more elaborate picture of inflation could only emerge in the months of April and May. With the lockdown being extended till May 03rd, the whole of April will go away with the economy virtually locked up. This has created a huge disruption of transport services and one of the biggest reverse migrations of people from cities to villages. Demand will be largely regulated in April and hence inflation would still be under check. The real test will be in the month of May when the normal demand is expected to return for most of the products in the CPI basket. If at that point, the supply side constraints start to play a role then retail inflation could shoot higher. Government needs to watch out as it winds down the lockdown over the next 3 weeks.