Deconstructing inflation

In its most recent policy statement on August 4 (hereafter PS), the RBI rigidly(strictly,सख्ती से) kept to its no-rate cut stance(attitude,रवैया) and justified it on the grounds that year-on-year inflation in June had perked up(gain,increase,बढ़ना) to 5.4 per cent from 5 per cent the previous month. This is what the PS said: “Headline consumer price index (CPI) inflation rose for the second successive month in June 2015 to a nine-month high on the back of a broad-based increase in upside pressures , belying consensus(agree,सहमति) expectations. The sharp month-on-month increase in food and non-food items overwhelmed the sizeable ‘base effect’ in that month.”

To really warn the public about widespread inflation, the PS added: “Furthermore, excluding food and fuel, inflation rose in respect of all sub-groups other than housing... Inflation in CPI excluding food, fuel, petrol and diesel has been rising steadily since April and exceeded headline inflation through Q1. Near-term inflation expectations of households returned to double digits after two quarters... Rural wage growth was moderate but there are indications of incipient(beginning,आरंभिक) pressures from corporate staff costs”.

Readers of this column know that for more than a decade, I have warned against the dangers of using y-o-y(year over year) data for making policy. Let me illustrate for the umpteenth time. Assume the CPI is 100 in January 2014 and there is zero m-o-m(month over month) inflation till June 2014. In July 2014, there is 10 per cent inflation, and thereafter again there is zero m-o-m inflation till October 2015. The RBI y-o-y inflation measure will show 10 per cent inflation till June 2015, even though for the last 12 months there has been zero inflation. Only after a year of wrong data and inference would the y-o-y data get back on track and show the “correct” inflation.

Policymakers get around this problem by looking at seasonally adjusted data. The RBI does not officially use seasonally adjusted data — perhaps, with outside experts’ influence on the Monetary Policy Committee, they will now begin to do so. The table shows inflation data for a wide variety of CPI indices, for the January-June 2015 period. The June RBI PS (when repo rates were cut by 25 basis points) was based on CPI data till April; the August statement had data available till June — hence, the grouping of data for January-April; May-June data are reported separately in order to constructively assess the RBI’s inference of an across-the-board acceleration of inflation.

The table shows annualised rates for both unadjusted and seasonally adjusted data. Look at the CPI excluding food, fuel and light, and petrol, or core CPI inflation. Fuel and light includes electricity, kerosene, charcoal, etc, but excludes petroleum, which has approximately a 2.4 per cent weight in total consumption. Core CPI inflation shows a decline in the unadjusted data in June — only a 5.2 per cent rate compared to 5.9 per cent in May and an average of 5.6 per cent for January through March. This certainly does not fit with the RBI perspective of across-the-board inflation increase. Why the different result? Because the RBI persists in using y-o-y data.

Further justification is provided by noting the marginal decline in the miscellaneous category of expenditures. This is part of core CPI and accounts for more than 28 per cent of total CPI. It shows only a marginal decline in June to a 9.3 per cent inflation rate, which by all accounts is very high — up from an average of 3.4 per cent between January and April. However, at least 40 per cent of this category (via NCAER input-output tables) consists of services. Service taxes went up in June 2015 from 12.36 per cent to 14 per cent. If prices remained constant, this would mean an increase of 1.4 per cent in the price of the service good, or an inflation rate of around 17 per cent (since the tax increase happened in just one month). Adjusted for service tax, miscellaneous goods and services registered a maximum price increase of only 5.6 per cent in June, a level almost half of the 10.4 per cent observed in May 2015.

Seasonally adjusted data confirm the real story that inflation is falling, and falling across the non-food board. These data suggest that the outlier in the January-June inflation pack is May, and there appears to be a steep reversion to the mean in June. One reason for the high May inflation was that there was generalised panic about El Niño and a possible drought for the second year running.

It is likely that the caution that Governor Raghuram Rajan and the RBI exercised in their August meeting had a lot to do with the May inflation data rather than the latest June data. It is also likely that this is what Rajan was hinting at when he said that one should not rule out an inter-meeting rate cut. If July’s inflation data are as benign(Kind,दयालु) as June’s — and we expect it to be so — then May is the exception in the last seven months. As such, like the rest of the world, India is also moving towards lower inflation, and lower repo rates.

What is consistent with this conclusion is the doveish anomaly(unusually,अनियमितता) in the otherwise static hawkish(unpeaceful,युद्धकारी) RBI policy statement. Because of softer crude prices and a near-normal monsoon so far, the RBI projects January-March 2016 inflation to be lower by 0.2 percentage points, that is, to be 5.8 per cent rather than 6 per cent. As several commentators have pointed out (including the RBI), there is a very loose connection (if at all) between food-production decline and food inflation. In its April and June PSs, the RBI was correctly advising the government that it was watching “food management” as an instrument of inflation control. FAO food prices, as of June 2015, are down 21 per cent y-o-y. This, along with excess food stocks in wheat and rice, means the government can comfortably ride out the weather-induced price storm, if there is one. So if the RBI is lowering its year-end estimate, the soft June data may be responsible!

One final observation about the RBI and inflation forecasts. The RBI estimate for y-o-y inflation in January 2015, made at this same time (August) last year, was 8 per cent. It turned out to be a grand miss, with actual y-o-y inflation in January 2015 about 300 basis points lower at 5.2 per cent. What happened? A favourite explanation of many commentators, inflation experts, and Congress party officials was that this decline had a lot to do with the international price of oil declining from $105 per barrel (June 2014) to $47 per barrel (January 2015). That is a (log) decline of 80 per cent. Petrol consumption is 2.4 per cent of total expenditure, so this would have brought inflation down by 192 basis points. So, maybe the RBI wasn’t that far-off from its estimate — they erred by only 100 basis points. In the larger scheme of “forecasting”, this is not so bad.

But it is. The CPI reflects the cost of petrol you and I pay. As the international price of oil declined, the government (Centre plus states) mopped up(wipe out,सफाया) a large part in taxes. Domestic price of petrol fell by only (log) 15 per cent, so the approximate effect on the CPI of the international price of oil falling was only 36 basis points — that is, adjusted for oil, inflation in January 2014 should have been 7.6 per cent. The RBI, even aided by the oil price decline, was off by 240 basis points in a forecast of y-o-y inflation only five to six months forward.

Will the RBI’s forecast for January-March inflation be off, or will the RBI reverse to the mean and be right? Time will tell. But all things considered, the odds are greater that January-March inflation will be closer to 4 per cent than the RBI’s 5.8 per cent.