India’s High Core Inflation — Whodunit?

The economic crisis brought on by the Covid-19 pandemic threw up a number of surprises. Among them was the question of core inflation and why it didn't collapse even as the economy contracted 25% in the first quarter of FY21.

Core inflation, by its very definition, is most impacted by demand conditions and should have fallen as demand weakened. But it didn't.

“The level of output will be almost 7% below its pre-pandemic path in March 2021. In contrast, emerging markets, in the aggregate, will be about 2.5% below their pre-pandemic path. Despite this, core inflation actually accelerated in India over the last year, firming to 5.3% from 4.4% the year before the pandemic, and defying all predictions that the dramatic hit to activity would be disinflationary,” Sajjid Chinoy and Toshi Jain of JPMorgan wrote in a report titled ‘India's Inflation Mystery: Whodunit?'

Why didn't core inflation fall as predicted? And what does it mean for policy-making ahead?

According to JPMorgan's analysis, a few factors played into the high core inflation with one surprise element.

The two predictable factors were higher input costs, as commodity prices firmed up, and elevated inflation expectations in response to a period of high food inflation. The third factor, which JPMorgan's analysis suggests was “very economically and statistically significant”, was the “speed effect”.

What is the speed effect?

It suggests that core inflation is not just a factor of the ‘level of slack', which is defined as actual output relative to potential output in the economy. It is also a factor of the ‘rate of change of slack' in the economy.

In the case of the Indian economy, which saw a precipitous fall in output in the April-June quarter but a sharp sequential rebound thereafter, the ‘rate of change of slack' may have had a significant role to play in the high core inflation. “When the rate of growth is higher than the economy's potential rate of growth, price pressures may emerge,” Chinoy and Jain wrote.

Implications For Policy

The elevated core inflation added to the dilemma faced by India's Monetary Policy Committee over the past year and led to an overshoot of the inflation target for eight months of 2020-21 .

The impact of the “speed effects” is expected to wane in 2021 as sequential growth momentum continues to slow, said JPMorgan.

While year-on-year growth is seen at 13% due to a favourable base, sequentially, GDP growth is expected to slow from a double-digit rate in the January-March 2021 quarter to 5% in the October-December quarter. “So the impact of speed effects on inflation should progressively attenuate even as the output gap, in levels, is progressively closing.”

Still, risks to inflation remain. This time from rising input costs, which may eventually be passed down via an increase in output costs and keep core inflation elevated.

Cost pressures pose a key risk in 2021 amidst a global reflationary backdrop, the report said. So far, these input cost pressures have not led to a commensurate increase in output prices. As a result, margins – as proxied by the difference in the composite PMI input and output prices – have begun to tighten sharply, said the economists, adding that margin pressures may eventually force firms to pass on these prices. In addition, any reversal in the slowdown in wage growth, could push up cost pressures further.

All this will put pressure on monetary policy to turn less accommodative.

“Monetary policy was the prime mover in 2020. But with core inflation momentum firming further in 2021, in the wake of a yet-incomplete recovery, policy trade-offs have only sharpened. The ability of the central bank to remain very accommodative will eventually come down to the evolution of core-inflation, in our view,” Chinoy and Jain wrote.