Forget The Rains, Temperature Matter More For Inflation, Says HSBC India

Temperature does a much better job of explaining and predicting food output and inflation, according to HSBC India. This view comes amid the sharp rise in correlation between the average temperature and India's food inflation over the last decade.

Average temperatures and volatility have increased over time. In India, the impact of the March 2022 and March 2024 heatwaves is fresh in the mind. The correlation between average temperatures and India's food inflation has risen sharply over the last decade, according to research by HSBC India. This is true across individual food groups—perishable crops, durable crops, and animal protein sources.

If the importance of temperature has risen over time, what role do rains and reservoirs play? Changes in reservoir levels, minimum support prices, and government food management steps can all help to explain food inflation. However, the study's findings indicate that adding temperature to the food inflation mode diminishes the significance of reservoir levels. They get 'crowded out'. When the researchers include temperature but exclude reservoirs, the model becomes even better than before in predicting food inflation.

This means that temperatures have become far better than rainfall in explaining and forecasting food inflation, according to Pranjul Bhandari, chief India economist at HSBC. There are several possible reasons. One, with irrigation facilities improving over time, the impact of low rains can be better managed, while there's no magic wand for dealing with rising temperatures. Two, reservoir levels and temperatures have a 50% correlation. A lot of the information contained in the reservoir variable gets picked up by temperature. Three, there is a non-linear relationship between temperatures and food inflation. With temperatures rising, the sensitivity of non-perishable food inflation to average temperatures has grown even faster than perishables.

In the short run, what should we expect? Following the debilitating March heatwave, temperatures have normalised. "Applying our model coefficient, food inflation could fall by 2 percentage points over the next few months, lowering headline inflation by 1 percentage point," Bhandari said in the report. Headline inflation has averaged about 5% so far in 2024. By end-2024, headline, core, and food inflation are all likely to converge towards the 4% target, opening up space for rate easing, she said. "We expect two 25-basis-point repo rate cuts, bringing the policy repo rate to 6% by March 2025."