The inflation spectrometer

Even as some inflationary impulses fade, others of more recent vintage pose new and bigger risks; one must disentangle multiple strands to reduce risk of policy errors

An idealised wave has a predictable pattern, with smooth, alternating up and down moves. The reason waves in the real world (like those in the sea or light waves from a remote galaxy) appear so complex is that there are multiple waves interfering with each other, creating apparently unpredictable patterns. A spectrometer helps disentangle this jumble of electromagnetic waves, say, to know the age of a galaxy.

It is similarly possible to isolate some economic impulses behind the seemingly complex inflation trends. In theory, inflation is a macroeconomic phenomenon, and analysing it by category is unwise, as prices shift both supply and demand between categories — sometimes global and local factors mix as well. For example, higher oilseed prices could shift acreage from pulses in the upcoming Indian kharif crop, pushing up prices of pulses even though the initial supply disruption was in Ukrainian sunflower oil.

However, most such shifts take time to play out, and it is possible to isolate some of the major driving factors, which can then help inform the outlook on inflation.

On the global front, there are two clear strands. The first started with the US fiscal stimulus during Covid-19, which was, in hindsight, much larger than necessary, pushing US retail sales ten standard deviations above normal. Delivered during lockdowns, it accentuated the services-to-goods switch in consumption at a time when global production was impaired. This not only pressured supply-chains globally, but also overwhelmed US ports, inland transportation, and then global shipping by locking up 4 per cent of the global shipping capacity in queues outside US ports. The resultant shortages and longer delivery times then shifted buyers from “just-in-time” to “just-in-case” when fixing inventory thresholds. This desire for more inventory exacerbated shortages, and meant an abnormally strong bullwhip effect for upstream materials.

The downward lash of this bullwhip is now starting, which can push apparent demand well below real demand. US federal fiscal deficit as a share of gross domestic product or GDP in the last three months is the lowest since June 2019. As services restart, a goods-to-services switch in consumption is underway; shipping bottlenecks have eased (though not fully); global industrial production got back above trend in February (though recent lockdowns in China hurt); and there is evidence of excessive inventory in many supply chains. Prices of TV panels and memory chips are falling, and the year-on-year price increases in metals are now much below those seen in April. Prices may not go back to the pre-Covid levels (meaning deflation from here), but the inflationary impulse does seem to be behind us.

The wage-price spiral (when higher prices lead to higher wages, which in turn drive the next round of price hikes) now visible in US services matters less for inflation in the rest of the world, but may still necessitate further monetary tightening in the US.
 

Illustration: Binay Sinha

The second global impulse, the start of the Russia-Ukraine conflict, may be harder to adjust to, with demand and supply adjustments likely to take many quarters. The conflict and the associated sanctions have reduced the global supply of food and energy. Given that global GDP growth and the use of dense energy are intimately linked, fiscal and monetary measures can only redistribute what remains between countries; they cannot offset the shortages. Nearly every major economy has announced energy subsidies — while this is understandable, given the domestic political compulsions as well as the need to sustain growth, they will only prolong the period of higher energy prices. This can be seen as countries competing for the remaining supplies of energy, pushing up prices until the weak hands (countries) give up. Higher prices have also not triggered investments in new supplies yet, as suppliers lack certainty on how long the shortages may persist. These trends could keep prices higher for longer than currently anticipated.

There exist tight links between the food and energy ecosystems today, through both supplies (higher fertiliser prices push up farming costs), and demand (blending of bio-fuels picks up when crude oil becomes expensive). Thus, both global food and global energy prices can continue to pose inflation risks.

Moving to local drivers of inflation: Inflation occurs when a stimulus pushes aggregate demand above the economy’s capacity to meet it. Even though state governments’ deficits are much lower than budgeted, the total government deficit in India is higher than in pre-Covid times. The recent fiscal steps to prevent a rise in fertiliser and fuel prices, while prudent and to some extent necessary, may serve only to spread inflation over a longer period. The rise in India’s current account deficit (CAD), with May balance-of-payments (BoP) deficit run-rate at nearly 2 per cent of GDP, also suggests domestic demand, at least in its current mix, is unsustainable.

However, some of the rise in fiscal deficit is due to a higher interest burden, which has low inflationary impact. The most important driver of sticky inflation, the labour market, still has slack. Demand for NREGA work, the most reliable indicator of unemployment in our view (even though a bit imperfect), has reduced, but is still higher than in pre-Covid times. While vegetable prices can drive significant volatility in headline inflation (like tomatoes currently), over the past decade the range of prices for most vegetables has not changed meaningfully. A major reason behind that is moderate growth in wages.

There are also some idiosyncratic drivers of Indian inflation that should be short-lived, like the rise in telecom tariffs from unsustainably low levels, and the low base of cereals prices last year caused by surpluses from the free grains scheme spilling into the market.

We may go through several months of high and volatile year-on-year inflation, on which the Monetary Policy Committee’s targets are set. However, given the step-jump in global energy and food prices, that indicator may be backward looking, and remain elevated until the high prices come into the base. Month-on-month changes in the consumer price index may provide a better measure of persistent inflationary impulses in the economy that monetary policy can try to address. Further, while normalisation of rates is inevitable given the healthy post-Covid recovery, letting the rupee weaken may be the best approach to address the BoP imbalance, instead of using interest rates as a brake on the economy, given the labour market slack. It would also be prudent to take cautious steps until the impact of global monetary tightening on demand and prices is clear.

The writer is co-head of APAC Strategy and India Strategist for Credit Suisse