Sunday, August 9, 2015

Inflation Paradox: Why rural CPI inflation is higher than urban CPI inflation

The main culprit behind the recent increase in India’s CPI inflation is rural India, while the urban CPI inflation has been largely under control. To put things into perspective, consider these facts. Total CPI inflation in November 2014 was 3.3% of which 1.8 percentage points (ppt) were contributed by rural CPI and 1.5 ppt were contributed by urban CPI. From November’s 3.3%, India’s CPI inflation surged to 5.4% in June 2015 led by 3.5 ppt contribution by rural CPI and 1.9 ppt by urban CPI. The contribution of rural CPI inflation has nearly doubled from 1.8 ppt in November 2014 to 3.5 ppt in June 2015 as compared to relatively lower contribution of urban CPI inflation from 1.5 ppt in November 2014 to 1.9 ppt June 2015.
What is more paradoxical here is that rural inflation has nearly doubled since November 2014 at a time when rural demand is going through the worst down cycle in over a decade. Here are four factors that tell the story of rural distress. One, nominal rural wage grew merely at 2.6% in May’15, the slowest pace since June 2005. Moreover, real rural wages have actually witnessed a contraction in nine of the last 10 months. Two, minimum support price (MSP) of agriculture produce grew at 1.6% and 2.9%, respectively in fiscal 2015 and fiscal 2016, the lowest in last 9 years. Three, foodgrain production of rabi crop contracted by 7.2% in 2014-15 over 2013-2014 as unseasonal rains in March 2015 destroyed a significant chunk of standing rabi crop. Four, the rural economy is reeling under negative wealth effect as the land prices in rural areas have fallen by around 20% since the peak of 2013-14.
What is more baffling is that milk inflation in rural India, which is the source of milk supply for the entire country, at 7.9% is 200 bps higher than milk inflation in urban India. Even inflation for cereals in rural India at 2.8% in June 2015 is 240 bps higher than in urban India. A simple logic suggests that pace of price increase should be lower in rural India than in urban India as the latter completely depends on the former for the supply of these items.
Similarly, rural inflation for recreation and amusement category, which includes cost of movie ticket, hotel lodging charges, monthly charges for TV cable charges etc, has gone up from 4.2% in November 2014 to 5.8% in June 2015 while urban inflation for the same category eased from 5.1% to 4% during the same period.
Is data collection a problem? Price data in rural and urban India is collected by two separate bodies. National Sample Survey Office (NSSO) collects price data for urban CPI and Postal Office is responsible for collecting price data for Rural CPI. While data collection is the core function of the former, it is an additional responsibility on the latter. NSSO has employed thousands of qualified field officers from statistics/economics background for the data collection work. On the other hand, price data in rural India is collected by postmen, who obviously are not the best qualified persons for the job and it is plausible to have a doubt on the quality of price data collected by them. Highlighting this issue, a Reuters article had quoted a postman, “Sometimes during the rainy season, I am unable to go out. Then I have no option but to fill in the prices of different items myself, ...usually I go to shops once or twice in two or three months to check price trends and fill in the price details myself by cross-checking with my wife”. The more worrisome part is that these numbers are key ingredients for monetary policy decision-making by the RBI, risking a case of garbage in garbage out.
There is no reason for such a sharp spike in rural inflation to sustain given that rural demand has slipped to a decadal low. Hence, lower rural demand would pull the rural inflation down in coming months.
Outlook on monetary policy: While RBI kept the policy rate on hold on 4 August 15, it is looking for more clarity on impact of monsoon on inflation trajectory and timing of the Fed “lift-off” before easing the repo rate further. Interestingly, RBI has lowered January 2016 inflation projections by 20bp to 6.1%. CPI inflation, however, is likely to be at 5.4% by January 2016 due to likely fall in rural inflation and lower crude oil prices – both are not factored into RBI’s inflation model – providing a 70bp downside to RBI’s inflation projections. Therefore, RBI may prepone another rate cut of 25bp on 29-Sep’15, given uncertainty over many key issues – sequential increase in food prices over the past two months, monsoon in Aug-Sep and fed rate action etc – will be over by then. Moreover, favourable change in some of the key liquidity enhancing factors – improving CAD, change in household savings from physical to financial assets, strong deposit mobilization and low credit off-take – may push liquidity into surplus, leading to reverse repo becoming the operative rate. It could be an effective 100 bps cut in interest rates. Therefore, we may not be close to the end of the easing cycle yet and there is more downside left to the interest rates in India. 

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