Inflation in the Times of Corona (#4)
The article throws light on how supply disruptions and demand slumps are distorting prices during COVID
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There is hardly an economic statistic as important as Inflation, and yet so misunderstood. In its simplest form, inflation represents the changes in the price of a basket of goods and services of common use. Ideally, the items in the basket should represent what the common man is paying, and so the basket is built keeping in mind the consumption patterns of the population. For example, a population that consumes more dairy products will see a bigger proportion of dairy in its inflation basket. And since the consumption habits also differ across regions within the same country, the inflation baskets differ for the urban and the rural populations. Complicating the matters are the two types of popular inflation metrics — the Wholesale Price Index (WPI) and the Consumer Price Index (CPI). To understand them, we must remember the following differences between the two:
While WPI calculates the value of the basket of goods at the point of wholesale, CPI calculates the value of basket components at the point of retail, i.e. in the hands of the consumer.
Moreover, while WPI accounts for changes in only the prices of goods, CPI calculates price changes in goods as well as in services.
Across countries, Consumer Price Index (CPI) is easily the more popular metric. Even in India, while both WPI and CPI are estimated on a monthly basis, the central bank — Reserve Bank of India (RBI) — primarily tracks changes in CPI and accepts the goal of monetary policy as one to maintain price stability. Specifically, the RBI targets a CPI of 4 percent, with an acceptable upper tolerance limit of 6 percent and a lower tolerance limit of 2 percent, i.e. deviation on either side of the target rate must not be more than 2 percent.
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As this write-up discusses inflation, the discussion is restricted to CPI with the words used interchangeably. The following hopes to capture the importance of the variable, along with the trends in its sub-components — with the objective of understanding inflation in this time of crisis.
Breaking down Inflation
We know now that inflation is just the price change of the basket of goods. And the value of the basket is simply the sum of its parts, i.e. sum of the value of the items it holds. Accordingly, to form expectations about or to predict future inflation, understanding those sub-groups of items within assumes importance.
Source: Ministry of Statistics & Programme Implementation (MOSPI)
The table above highlights the weights of each sub-group in the CPI basket for the rural and the urban segments, as well as for the combined CPI statistic– more technically known as the Headline Inflation.
The focus in the analysis, based on their weights and tendencies, will be on three subgroups:
The importance of food and beverages in our regular expenditures cannot be overstated. Accounting for approximately half of the headline inflation, any shifts in the retail prices of cereals & products, milk & products, vegetables, pulses & products, and spices impacts the purchasing power of the Indian population greatly, more so in the lower-income rural areas.
The next subgroup that attracts great attention is Fuel and Light. One, due to the high volatility of its prices; and two, due to the exogeneity of the changes in its prices. The energy sector conditions along with the global fuel prices are two important determinants of any price changes in this subgroup.
Finally, the focus will turn towards housing, clothing, and footwear industries. The prices in these segments have historically been steadier compared to the above two subgroups. Interestingly, these form an important part of another retail inflation metric called Core Inflation, which is similar to CPI but excludes the food and fuel components in its calculations. Since the changes in food and fuel are often due to large transitory supply shocks, focusing on core inflation gives us a better idea of where the underlying inflation, i.e. price increase that is more structural and permanent in nature, is heading.
The COVID Dilemma
Economics 101 tells us that the interplay of demand and supply determines the prices in the marketplace. In simple words, the price of good increases if there is excess demand for it, and decreases if there is excess supply. The lock-down in response to the pandemic has impacted the supply chains of the sellers as well as the incomes of the buyers, upsetting both demand and supply. As a result, prices have seen unpredictable jumps and falls.
For each subgroup, I identify the pricing trends and the events responsible, based on which we can form crucial inflation expectations.
1. Food & Beverages: the supply chains break down
The restrictions on travel and transfers have placed many barriers on the supply chains of money, people, and healthcare but perhaps the biggest disruption is in the supply chain of food. As we entered lock-down, the Rabi crop was nearing harvest. We were eventually able to harvest most of it but with locked regional borders and lack of cross-state trades, farms and markets have seen widespread crop losses. Equally concerning has been the labour shortages on the farm fields due to the restrictions in the movement of the migrant farm workers. Luckily, with food-grain stockpiles large enough to feed its poor for one and a half years, India began the lock-down in a favourable position. However, before you celebrate, the poor supply infrastructure has meant that food stockpiles are quickly depleting.
Moreover, unlike the demand for durable and discretionary goods — that has seen a steep collapse due to lock-down, the opposite has happened for the demand for food. With people panic buying and hoarding food in fear of the unknown, the demand has seemed inelastic for food. As a result, with a limited supply of essential food items and the unfaltering demand for necessities, we can expect to see the same money running after fewer goods — pushing up the food prices in the near term.
However, the cost will be heavier for the poor and the low-income salaried class, who will reduce their consumption of non-essential goods. Worse still, some might have to pay for it in terms of lower food consumption and consequently diminished nutritional intake. The consequences for the health and productivity of workers can be disastrous. And with less food on the plates — there is little doubt that petty and organised crimes will see a sharp uptick.
Source: Ministry of Statistics & Programme Implementation (MOSPI)
The above graph already shows the impact of supply bottlenecks, with a trend reversal in retail food inflation. As it takes a few more months for the normalcy to return, we might see the number travail and remain above 10 percent for the time period. This will reign heavy on the already impacted incomes of the Indian population.
There are however certain causes to remain optimistic on the food and beverages prices:
Indian Meteorological Department (IMD) predicts the monsoon to be 100 percent of the long-run average this year, i.e. a perfectly normal monsoon. This is important since the four-month monsoon period starting from June accounts for 60–90 percent of the total annual rainfall and can be the difference between going hungry or not for millions of troubled families.
Secondly, there has been one particularly favourable regulatory development for farmers. Deregulation of farm foods from the Essential Commodities Act (ECA) gives farmers more headroom to price and sell their produce, which in the medium and long term should allow farmers to realise better prices for their produce.
What can the government do against the potential unfavourable increase in food inflation?
(A) Be wary of food protectionism: a report by Nomura indicated how protectionist traditional trade policies could lead to a surge in already increasing food prices. Nomura’s Food Vulnerability Index (NFVI) named India at #44 out of a list of 110 with large exposure to food price swings, and the government would do well to keep the nationalist sentiment away from the fields.
(B) Reconfigure Farmer Supply Chains: Instead of wholesaling in bulk, the farmers should be provided with facilities to sell directly to restaurants, hotels, grocery stores, and so on. This will allow them to realise better incomes and lower the dependency on the intermediaries, making the supply chain more efficient. This has long been a point of debate, and the crisis provides the perfect opportunity to fast track this move.
2. Fuel and Light: Demand deficit crashes prices
Price changes in the fuel and light subgroup are dependent heavily on the prices of electricity and LPG, which make up around 81 percent of the total component. As the demand for almost all goods and services slumps during the lock-down, the energy demand is expected to reduce by 30 percent on an annual basis — biggest since the World War Two. This is mainly on account of the fall in industrial and commercial power consumption even as household power consumption rises. Unfortunately, this can be the final blow for the already struggling power distribution companies, which are now dealing with falling electricity prices on the spot market. With the industrial machinery not expected to be in full flow until the year-end, we can expect a moderation in prices for the medium term as well.
The story is similar for the LPG, which makes up 32 percent of the fuel and light subgroup. Prices this month have come down by as much as 20 percent in metros with the slump in global energy demand. While panic buying led to increased sales of LPG cylinders in April and May, the LPG prices are primarily a function of the international benchmark rate of LPG and the exchange rate of US dollar and rupee — and not just the domestic sales. And with both variables acting to push down LPG prices, we can expect LPG prices to continue in the same direction for the next few months.
Overall, led by tremendous demand slump, this sub-group portrays a picture of weakening prices and is not expected to push up the pricing pressure on our pockets any soon.
3. Core Inflation: Housing, and Clothing and Footwear hung out by delayed purchases
Housing, clothing, and footwear form the less volatile components of inflation and can be called relatively non-essential commodities. And as it so happens during an economic crisis, the consumption for non-essential and discretionary purchases has safely taken a backseat.
Real estate agencies are echoing the same tune — a near-term halt in real estate sales. While housing in the Jan-March quarter had declined by 26 percent already, the lock-down is sure to make the situation worse. Even with the moratoriums, tax breaks, and lower interest rates, home loans are expected to decline with delay in housing project deliveries and with a global income slump. The low demand and the resulting accumulation in inventory can lead to a crash in property prices to the extent of 20 percent, although some voices imagine little change in prices. Either way, the inflationary pressure due to housing will be low for the common household. For potential home buyers, with safe cash reserves, this might even present a good opportunity to buy properties at their lows.
For the textiles, clothing, leather, and footwear (TCLF) industries on the other hand, the sales are spiralling down fast. While supply disruptions due to the unavailability of labour have been ubiquitous, the demand has dropped further with a projected drop of 50 percent over the financial year. Compounding the sales fall are the closed trade channels and the expected decrease in demand from major economies, even as the barriers slowly pull down.
Given the above trends, core inflation does look likely to hit a figure close to zero-to-one percent. The same has been estimated by many other research reports. This concludes the trends for the three key important sub-groups.
Too Long, Didn’t Read: Summary and the Final Words
After highlighting the major subgroups that form the inflation basket, I looked at the behaviour of demand and supply forces for each subgroup — based on which the expected pricing trends were recognised. The trends are summarised again:
Production and distribution disruptions are expected to weigh heavier on retail food inflation than the slump in demand, which is limited due to the essential nature of the goods. As a result, excess demand might push and keep food inflation above 10 percent for a series of months, until the supply chains are running back again.
Lack of industrial and commercial power consumption behind the closed doors are pushing the electricity prices lower on the spot market, and the LPG prices on account of fall in global benchmark rates and INR depreciation are witnessing a fall of ~20 percent in the metros across April and May. The demand slump is not expected to go away until the lock-down ends, and we can expect the prices to remain weak or even turn negative for the light and fuel subgroup as a result.
Finally, the plunge in demand caught up most with the relatively less essential buys of housing, and textiles, clothing, leather, and footwear (TCLF) items with individuals delaying their purchases in the face of uncertainty. Real estate prices are expected to see a correction to the extent of 20 percent, while the unavailability of labour and the closed trade channels are contributing to the expected fall of 50 percent in TCLF products.
There are reasons to believe that we might see deflation (fall in prices, or negative inflation) in the near-term with the aggregate demand overwhelming the aggregate supply disruptions in the economy. But with a weight of ~45% to food inflation in the entire basket, and the possibility of supply chain disruptions and an ever-threatening poor monsoon, we must be wary of retail food inflation overpowering the rest of the components and eroding our purchasing power. This will be especially troublesome as food occupies a great proportion of our consumption during the crisis and the government moves towards the nationalist rhetoric of traditional trade barriers, stocking the inflation up even more. So keep a close eye!
Either way, I hope this little exercise was informative. Please feel free to leave any feedback in the responses below!