India's Inflation Pressures Broad-Based, Says HSBC's Pranjul Bhandari

Yes, absolutely.

In fact, I would say that the year-on-year CPI inflation number was 7.8%. But if you look at the sequential momentum, which technically we call the seasonally adjusted quarter-on-quarter annualised inflation, that was actually 9%. So, it was even higher than the year-on-year number we saw.

There are across the board pressures—food, fuel, coal. Interestingly, if you parse through the details, you will also realise that this is not the end of it. There's going to be a lot of upward pressure even from here because a lot of the pass-through is still is not complete.

I must say that the next two months' readings, for May and June, will be lower and closer to 7% simply because of base effects. Once May and June have passed, then the numbers could jump back up again. So don't get very comforted just because May and June inflation will come out lower.

Some of it is going to be across the board. Agricultural input costs have increased 15% year-on-year, based on the last reading. That's considerable and it's going to impact all food items.

I think for me, the most worrying part has been what's happened to cereals. Cereal inflation in India has been under control for several years and it has been the main driver of low food inflation in India. This has now changed.

A lot of people ask what prompted the RBI to announce a surprise rate hike. I think part of it is the fact that the nature of food inflation was changing a lot. Till March, we were expecting to have a very good wheat crop, so we were thinking that we can feed the world, we can export. Then suddenly you got a heat wave, the wheat crop shriveled at a time when the stocks at Food Corporation of India are not as elevated as they were two years ago, at a time when flour mills are not being able to import from Ukraine and Russia. So there is a wheat problem.

Looking ahead, rice and wheat are close substitutes. So, a lot of pressure could pass on to the rice crop as well. If the monsoon rains don't turn out well, in case we have some fertiliser shortage, and we have some problem with the rice crop, then I think things could get worse .

Hopefully we won't get there. But I think cereal inflation is really very important to watch.

[Note: Late on Friday, after the recording of this interview, the government announced a ban on wheat exports]

Yes, I think the fuel story is a very interesting one.

We talk a lot about pump petrol and diesel prices, so we know what's going on there. Alongside kerosene, which is the main lighting fuel in rural India and is unregulated, has really shot up.

The other thing that has shot up is bulk diesel. Again, this is something used a lot in rural India for agricultural pumps.

So, we have seen parts of the fuel basket, which rural Indians use, shoot up aggressively.

On the other hand, if you look at electricity tariffs, they haven't really gone up yet. Generally, electricity tariffs, which are dictated by the distribution companies, take about 12 to 18 months to be revised. That will eventually have an impact on urban inflation.

I think this fuel story, where kerosene and bulk diesel prices have gone up, but electricity tariffs haven't, is the main reason why rural inflation is so much higher than urban inflation. I think this is an important point to keep in mind.

Eventually, when electricity tariffs are increased, urban inflation will begin to catch up and hurt purchasing power, which has been the main driver of growth. That will have growth implications.

Yes, I think, unfortunately, the rural economy hasn't been doing well since the middle of last year.

Many things have come together, starting from volatile rains last year, to MGNREGA support being a little lesser than people had anticipated, and no big increases in PM Kisan Yojana allocations. Also, construction demand has been a bit volatile because of unseasonal rains. So, a lot of things came together.

So with high rural inflation, the pressures will remain. Generally speaking, rural demand is weak. I would watch out for two things. First, good monsoon rains could lead to some improvement in rural India. Second, if construction activity picks up, especially in urban India, that will help since this is now a main source of wages for rural Indians.

With such big increases in input costs, at some point, producers have to pass it on to the consumers and that's what we are seeing.

Core inflation pressures were visible across the board, including personal goods, household goods, household services. It's understandable but my worry is that the pass-through of higher input costs from producers to consumers is still about 50 or 60% of what is generally passed on.

In fact, if I drill in deeper, it seems to me that for goods inflation, for goods producers, a lot of the pass-through has happened but for services producers, a lot of the pass-through has still not happened. When that picks up, my worry is that core inflation could remain sticky for longer.

The other worry is that, through the pandemic, we have seen formalisation. We have seen large firms getting larger, we have seen large firms gaining pricing power. Once they have increased prices, because input costs went up, they get comfortable with those prices and even if at some point input costs go down, they don't cut as fast as they raised prices. So that's another source of stickiness that we may see in core inflation.

Even before global inflation began to rise in 2021, right through 2020, we had elevated core inflation in India. So, what was really going on at a time when the economy was contracting? I think the story is very India-centric.

I think there were two forces at play—what was happening to the small firms and what was happening to big firms.

Small firms saw a lot of disruption. They have no cash buffers. When there were lockdowns, many of them were forced to shut down and there was a disruption in supply. We also see that many of the small informal firms are producers of necessary goods, like clothes and food items, for which demand didn't really fall very much. So, if the supply fell because these firms went out of business, it basically meant high prices. So that was one source of high inflation coming from small firms.

The story was exactly the opposite for the large firms, which had gained pricing power, and generally kept prices higher than they would have otherwise. That was another contributor to core inflation and I think that's why we saw high core inflation through the pandemic period.

Yes, I think it's very important to be clear upfront about what the RBI is capable of doing with monetary policy and what is beyond their control.

I think what's beyond their control is the source of the shock, which is a supply shock coming from global commodity prices, the Russia-Ukraine crisis, heat waves, etc. None of that can be changed by the RBI. So, we have to be very clear about that.

But what RBI can do is to take care of some of the second-round effects and that is what the RBI is trying to do. Second-round effects control is never full, it's always partial, particularly in a country like India where we have such a large informal sector and the transmission lags are two to three quarters.

Our best hope is that the RBI removes some of the extraordinary accommodation of the pandemic period and that helps bring down inflation expectations or rather keeps inflation expectations from rising too much and that becomes a primary tool of inflation control.

Another tool of inflation control is that as you keep hiking rates, the demand for credit comes down and, therefore, inflation associated with that also comes down. But here RBI will have to tread a really fine line.

It's very important to take real interest rates out of the negative terrain, where savers are getting punished. But how positive do you want it to be? Do you want to go all the way to where you think neutral real rates are or do you want to stay a little under that? My sense is that RBI may want to stay a little under neutral real rates and, in that sense, strike a balance between both growth and inflation.

The neutral real rate before the pandemic was just above 1% by RBI's own research. My own terminal rate forecast, which is 6% repo rate by June 2023, implies for me that they will take India's real repo rate to just under 1%. So that's what I am forecasting at this point and, for me, that is the fine balancing line.

Just to make it a bit clearer, right now the repo rate is 4.4%. I think there will be a couple of pit stops. The first pit stop would be to cross a repo rate of 5.15%, which is where the repo rate was at the start of the pandemic. This is likely to be achieved by end-September. The next pit stop will be taking the repo rate to 5.5%. This is an important number for me because the one-year ahead inflation forecast at that stage is 5.5% for FY24. So, taking the repo rate to 5.5% means that you are finally coming out of negative real rates.

I think we will reach a repo rate of 5.5% by December 2022. Once we are there, my sense is the RBI will take a very careful look at growth. If growth allows, they will hike a little more. My sense is that they move from 5.5% repo rate to 6% and at that point, we would be just under neutral real rates.

It's a hard question.

We always think that low rates bring growth, but we will also see that in India’s case low rates were not able to trigger a private capex cycle as many had hoped, at least in previous cycles. So, this is a tough one.

I do think that very high rates at some point will start hurting growth. But the rate hikes I am talking about right now are just about taking India to safe territory, taking India towards positive real rates, which I think is necessary to have sustainable GDP growth.

I have looked at this very carefully. My sense is, at this point, the biggest dampener to private capex is not rates or liquidity withdrawal, but economic uncertainty. The fact that we are finding it very hard to forecast growth, inflation, commodity prices, with a huge level of confidence at this point.

There are so many moving parts around the world. When you see this kind of economic uncertainty, the first thing to pull back is private capex and I think that's the biggest problem right now. In a hypothetical situation, in which this economic uncertainty goes out of the window but rates are a little higher, my sense is we will start seeing private capex pick up.