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. 

Easing though liquidity route to continue, 100bps cut in repo rate in 2013

Due to high inflation, the RBI today kept the repo and reverse-repo rates unchanged, at 8% and 7% respectively. However, in order to keep liquidity into its comfort zone, RBI cut the cash-reserve ratio (CRR) 25bps, to 4.25% of net demand and time liabilities (NDTL). The move would inject Rs 17,500 cr liquidity into the system. Taking the liquidity route to ease monetary policy, the RBI has cut the CRR by 175bps in last ten months.

The RBI has revised its FY13 GDP forecast downward to 5.8% from 6.5% in Jul ’12 policy. The WPI inflation target for Mar’13 has been revised to 7.5%, from 7% earlier.  Both deposit and non-food credit growth has been revised downward by 100bps to 15% and 16%, respectively.

100bps cut in repo rate in CY13. Given upside risks to inflation till Dec ’12, a rate cut by RBI until Dec’12 is unlikely. I expect the central bank to focus on easing liquidity through open market operations (OMOs) and by slashing cash reserve ratio. I expect WPI inflation to peak out at 8.5% in Dec’12. Likelihood of a bumper rabi crop and strengthening rupee, coupled with a favourable base effect, are key factors which could soften WPI inflation considerably post Dec’12. I expect WPI inflation to soften to 6.1% in Apr’13. Accordingly, I expect 100bps repo rate cut in 2013 with the first cut starting from Feb-Mar ’13. In its guidance, the RBI also said, “the baseline scenario suggests a reasonable likelihood of further policy easing in the fourth quarter of 2012-13”. Until then, the RBI is likely to continue with the liquidity enhancing measures – CRR cuts and OMOs – to support growth.

Cost of loan likely to increase further as the RBI up the policy rate

Continuing with its calibrated monetary tightening cycle, the RBI today hiked the repo and reverse repo rates by 25bps each. This is a reaction to the high and sticky inflation, which continues to be nearly double the medium-term target of the RBI since Jan ’10. RBI now projects WPI inflation at 8% by end-Mar ’11.

The repo rate – the rate at which banks borrow from the RBI – now stands at 6.75% and the reverse-repo rate – the rate at which banks park money with the RBI – at 5.75%. Today’s rate hike in the policy rates marks the eighth consecutive hike since Feb ’10. Overall, the RBI has hiked repo rate by 200bps, reverse-repo rate by 250bps and CRR by 100bps in the ongoing rate hike cycle. However, the effective rate hike in the operative rate has been 350bps as the operative rate has changed from reverse repo to repo rate due to change in the liquidity situation.

The RBI has increased WPI inflation projection for end-Mar ’11 to 8% from 7% earlier. WPI inflation inched up, to 8.3% in Feb ’11, after softening to 8.2% in Jan ’11. Notably, the RBI has mentioned that non-food manufactured products inflation continues to be Ill above its medium-term trend – it rose sharply, from 4.8% in Jan ’11 to 6.1% in Feb ’11 – indicating that producers are able to pass on higher input prices to consumers.

What next. The food articles inflation has started considerably softening on account of improved supply and the trend is expected to continue on a likely bumper rabi crop, which will hit the market early next month. The main pressure to inflation, going forward, is likely to come from manufactured products. I expect inflation to remain elevated (7% average) in FY12. I expect the RBI to hike policy rates once more by 25bps each in the next monetary policy meeting on 3 May ’11.

Now, the cost of loans is likely to go up further. Clearly, this negative for the Real estate, auto industry and other interest rate sensitive industries. So, guys, be ready to face a high interest rate environment and plan your expenditure accordingly.

India's central bank takes a breather

The RBI has taken a breather after following the aggressive tightening path since beginning-CY10. As headline inflation has started softening, managing liquidity seems to have become the main focus area for the RBI. We expect further tightening in policy rates, in FY12.

Key policy rates remain unchanged. In line with expectations, the RBI left the repo rate (at which banks borrow from the RBI) and the reverse-repo rate (at which banks park money with the RBI) unchanged, as per its mid-quarter monetary policy review today. The cash reserve ratio (CRR) was kept unchanged at 6%.

Break from policy rate hikes. After six consecutive policy rate hikes since Feb ’10, the RBI has taken a breather. The RBI has hiked repo rate by 150bps, reverse-repo rate by 200bps, and CRR by 100bps since beginning-CY10.

Focus on liquidity. In a bid to address the prevailing acute liquidity shortage in the system, the RBI took two major steps – One, it cut the statutory liquidity ratio (SLR) by 1%, to 24% of net demand and time liabilities (NDTL). This, however, has been counter-balanced by reducing the additional liquidity support under the LAF announced on 28 Nov ’10, to 1% of NDTL from 2%. Two, it announced that it would purchase government securities of `480bn within the next month through the open market operation (OMO).

Liquidity to remain tight. Despite RBI’s measures, we do not expect significant improvement in the liquidity situation in the near term. Post mid-Jan ’11, however, the tight liquidity situation may start easing.

RBI retains broad projections. The RBI has kept the FY11 GDP growth projection at 8.5%. As regards inflation, the RBI has indicated possible upside risk to its Mar ’11 target of 5.5% in the face of rising international commodity prices. WPI inflation considerably softened to 7.5% in Nov ’10, the lowest since Jan ’10.

Policy rate outlook. In line with our estimates of softening of both inflation and real growth rates in 2HFY11, we expect the RBI to maintain policy rates at current levels for remaining-FY11. However, RBI’s medium-term focus is likely to remain biased towards tightening. After softening to ~5.5% levels by Mar ’11, we expect inflation to start inching up post May ’11. Hence, we believe key policy rates would be further tightened by another 75bps in FY12e. Transmission of monetary tightening would keep upward bias for both lending and deposit rates

India moving ahead of peers by adopting hawkish stance on monetary policy

In its first quarterly review of Monetary Policy FY11, the Reserve Bank of India (RBI) hiked the repo rate (the rate at which banks borrow from the RBI) by 25bps to 5.75% and the reverse repo rate (the rate at which banks park funds with the RBI) by 50bps to 4.5%. The 50-bps hike in reverse repo rate was higher than the street expectation (25bps hike in both rates). Since the repo rate is the operating rate in the current liquidity shortage scenario, the 50 bps hike in the reverse repo rate will have only a limited role to play. From the policy document it is clear that the RBI’s focus has shifted to anchoring inflationary expectations in the economy.

Though the RBI seems sanguine on the economic recovery front, it showed deep concerned about the high inflation in the economy. The central bank increased the economic growth forecast for fiscal year 2010-11 to 8.5% from 8% earlier and the year-end inflation target to 6% from 5.5% earlier.

Another important announcement is that the RBI will now undertake mid-quarter reviews roughly at the interval of about one and half months after each quarterly review. Now this is welcome step, given the fact that in recent years, there have been several occasions when the RBI had to take off-cycle policy actions in response to macroeconomic developments. In fact the frequency of the intra policy actions had increased off late. For example, intra policy rate actions were taken in April, June, Sep and Dec in 2008; in Jan and March in 2009; and in March and July in 2010 so far.

On the policy rate outlook, assessing the current scenario, any change in policy rates during the 16 Sep ’10 mid-quarter review is unlikely. However, I expect 25-bps hike in repo and reverse-repo rates in the second quarterly monetary policy review on 2 Nov ’10

RBI takes on liquidity

In a rather hawkish move, the RBI increased the cash reserve ratio by 75 basis points to 5.75% in order to address the ongoing liquidity overhang in the system. Other policy rates were left unchanged. The move is expected to drain Rs 360 billion from the system. In the last one month, the overall liquidity in the market has been around Rs 600 to Rs. 800 billion. So factoring in RBI’s rate action, there will still be around Rs 300 billion to Rs 500 billion left in the system.

The comforting factor here is that central government is done with its massive market borrowing programme for the current fiscal. Nevertheless, the move is expected to raise short-term rates and will impact banks negatively. Banks would lose out on account of the increased CRR outgo. Given the current credit demand and deposit growth scenario, it would be difficult for banks to even partially pass-through the same through either a hike in lending or a cut in deposit rates.

As the wholesale price inflation surged to 7.3% in Dec ’09 and the consumer price inflation remains in the teens, the RBI is now focusing more on managing inflationary expectations. The RBI, however, has pointed out that the recovery is yet to fully take hold and that it would require sequenced withdrawal of exit from the current extremely accommodative regime.

To sum up, the recent aggressive tightening in the CRR indicates that the RBI will not take any rate action until the next policy review on 20 April 2010.

Analysis on the RBI’s monetary policy for 2009-10

The Reserve Bank of India (RBI) left its key policy rates unchanged in its first quarterly review of monetary policy for 2009-10 on July 28th. The repo rate – the rate at which banks borrow money from the RBI – was left unchanged at 4.75%, the reverse repo rate – the rate at which banks lend funds to the RBI – remained at 3.25% and the Cash Reserve Ratio (CRR) - the percentage of deposits that banks keep with the central bank was kept unchanged at 5%. The decision, however, didn’t surprise the market at all for its obviousness. The RBI had reduced the repo rate six times, amounting 425 basis points since Oct’08 in order to ensure enough liquidity in the system. As the liquidity situation has been quite comfortable for last 5-6 months and the inflation seems to be posing a threat in the second half of the current fiscal year, RBI’s decision of maintaining a status quo is completely plausible.

* With upward bias, ** end March

Growth outlook:
The RBI looked more sanguine about the domestic growth outlook yesterday than the last policy review in Apr’09. According the policy document, the business outlook in the country has turned positive signaling a revival of industrial activity. However, the RBI expects the export demand to continue to remain weak in coming months and the services sector may experience the drag of sluggish external demand and the lagged adverse impact of the weak industrial growth. Also, the below normal monsoon this year is likely to pull down the agriculture production for the Kharif season crop. Weighing all these factors, the RBI’s the growth projection for GDP for 2009-10 is placed at ‘6% with an upward bias’. I fee the RBI has been a tad conservative about the GDP forecast. As the recent macro-data points to a better economic environment, the economy is likely to grow at 6.5% in 2009-10.

Inflation outlook:
On inflation front, RBI expects the annual inflation to go up to 5% by the end of March 2010. It says that the WPI-based inflation, which has slipped below zero, has only statistical significance and doesn’t reflect a contraction in demand and may not persist beyond a few more months. However, it expressed concern about the elevated food inflation and an uncertain monsoon outlook could further accentuate the problem.

Regarding the money supply growth, the RBI projects the M3 money supply to grow at 18% during 2009-10. Furthermore, the bank deposit and the bank credit are projected to be growing at 19% and 20% respectively in 2009-10.

But I see the RBI will be having a bigger responsibility this time. As the fiscal deficit has been estimated at 6.8% of the GDP in 2009-10, the government plans to withdraw Rs 4.5 trn from the market in the current financial year. This has hardened the interest rate in the bond market. At the same time the RBI will have to ensure that there is enough liquidity left in the system so that the private sector also has easy access to the funds. But if the government goes little aggressive on the disinvestment plans, the situation could improve significantly with foreign money flowing into the economy.

Outlook for Rupee:
The RBI’s decision of keeping the policy rates unchanged doesn’t seem to have much impact on the rupee. However, a revival in FII inflows and an improved domestic growth outlook are likely to provide a support to the rupee in the coming months. Risk aversion is also expected to subside on possible global economic recovery towards the end of 2009. Therefore, I expect the rupee to inch towards 46.50-47 levels by end of Mar 2010. In the immediate term, however, rupee could continue taking cues from the direction of domestic equity markets and from the dollar’s movement against other major currencies.

To sum up the whole thing, I would like to add that the nine-month long easing cycle of the interest rate seems to have come to an end and the RBI’s next move will be to increase the key rates which might happen as soon as beginning of 2010.