India: CPI inflation falls under 4% on base effects and demonetisation

Perishable prices have fallen and there is some softening in core inflation as well

December 13, 2016

• CPI inflation moderated to 3.6% y-o-y in November, from 4.2% in October, lower than expected. The November CPI data suggest that demonetisation did have a dampening effect on perishable food items and the moderation in core inflation is also good news.

• We estimate that demonetisation contributed 25-30bp to the fall in headline CPI inflation via lower perishable prices, slightly more than the RBI’s estimate of 10-15bp. Meanwhile, most core inflation measures have eased by 20bp in November and stood in the 4.7-4.9% range.

• The key question is the sustainability of this downtrend in the coming year. In our view, both the growth as well as the inflation hit on account of demonetisation is transitory and we expect a stabilisation in macro indicators after Q1 2017.

• As the cash shortage eases in Q1 2017, we expect food inflation to move higher. Along with an increase in both nominal rural wages and minimum support prices, we believe that the pace of disinflation will taper off with CPI inflation averaging 5.3% in 2017 versus 5.1% in 2016. In particular, we expect CPI inflation to average 4.9% y-o-y in H1 2017, but at a much higher 5.8% in H2 2017, with 6% likely to be breached in Q4 2017.

• We expect the Reserve Bank of India (RBI) to cut by a final 25bp to 6% in February and then stay on hold through 2017.

November CPI data were closely watched to gauge the effects of demonetisation on price behaviour. In the event, headline CPI inflation moderated to 3.6% y-o-y in November, from 4.2% in October, lower than expected (Cons: 3.9%, Nom: 4.0%).

Much of the moderation was led by lower food price inflation, which eased to a two-year low of 2.1% y-o-y in November versus 3.3% in October (Figure 1). Fruit and vegetable prices fell over the month, partly due to seasonal factors (prices tend to fall in winter months due to increased supply) but also because of demonetisation (as the cash crunch limited the ability of middle-men to buy any significant stock, forcing farmers to sell perishable goods at lower prices). Price of other perishable food items such as meat, fish, egg and milk were flat or rose over the month (Figure 2). We estimate that demonetisation contributed 25-30bp to the fall in headline CPI inflation via lower perishable prices, slightly more than the RBI’s estimate of 10-15bp.

Even as perishable prices moderated, non-perishable food prices picked up sequentially led by higher cereal price inflation, which rose to a 25-month high of 4.9% y-o-y in November – a trend we expect will continue in December. Wheat prices have picked up due to lower buffer stocks and due to fears that while winter (rabi) crop sowing has progressed well, the cash crunch may hinder farmers’ ability to pay for other inputs such as labour, resulting in lower supply. Pulse prices, though, fell sequentially.

Underlying inflation witnessed some moderation this month. Core CPI (ex-petrol, diesel) eased to 4.9% y-o-y in November from 5.1% in October, while the trimmed mean CPI inflation eased to 4.7% from 4.9%. Since March, while underlying inflation has remained ~5%, there have been compositional changes. Inflation in beverages, intoxicants, housing, household goods and services, health, among others, have eased, but that has been partly offset by higher inflation in prepared meals and personal care category (Figure 3). The increase in personal care inflation is due to higher gold prices. Excluding gold, underlying inflation stood at 4.7% y-o-y in November. Hence, most core inflation measures have eased by 20bp in November and are in the 4.7-4.9% range (Figure 4).

Overall, November CPI data suggest that demonetisation did have a dampening effect on perishable food items and the moderation in core inflation is also good news. The key question is the sustainability of this downtrend in the coming year. In our view, as the cash shortage eases in Q1 2017, perishable food inflation will pick up again, pushing y-o-y food inflation higher (Figure 5). Moreover, demonetisation will result in wealth redistribution, especially benefitting the poorer households, who have a higher marginal propensity to consume, which along with improved banking system liquidity, will boost growth over time. As more firms move from the informal to the formal sector, there is also a risk that tax increases are passed to consumers. Overall, we expect both the growth as well as the inflation hit on account of demonetisation to be transitory with stabilisation in macro indicators after Q1 2017.

We also note that nominal rural wages, which have a high correlation (0.89) with CPI inflation, picked up to 6.9% y-o-y in October, partly due to the recent increase in basic minimum wages, which will put a floor on inflation (Figure 6). Minimum support prices have also risen by 5.1% in FY17 (summer & winter crop) from a low of 2.6% in FY15, on our estimates.Therefore, we expect the pace of disinflation to taper off with CPI inflation averaging 5.3% in 2017 versus 5.1% in 2016. In particular, we expect CPI inflation to average 4.9% y-o-y in H1 2017, but at a much higher 5.8% in H2 2017, owing to adverse base effects, with 6% likely to be breached in Q4 2017. Note that we have not factored in the pay commission impact, which can add 100-150bp to headline CPI inflation. On the monetary policy front, we expect the RBI to cut by a final 25bp to 6% in February and then stay on hold through 2017.