India’s Post-Covid Economy: The Inflationary-Deflationary Mix

Is the Covid-19 shock proving to be inflationary or deflationary? 

Customers wearing protective masks shop for vegetables from street vendors in Mumbai, India, on Monday, July 6, 2020. Photographer: Dhiraj Singh/Bloomberg
Customers wearing protective masks shop for vegetables from street vendors in Mumbai, India, on Monday, July 6, 2020. Photographer: Dhiraj Singh/Bloomberg

The Covid-19 crisis and lockdowns imposed to curb the spread of the virus, presented a unique challenge for economies, including India. It was a simultaneous demand and supply shock. Restrictions on movement impacted the supply, while a fall in jobs, income and regular business activities impacted demand.

Economists have been divided on whether the Covid crisis will prove to be inflationary or deflationary. Early indications ⁠— from inflation expectation surveys and now inflation data ⁠— suggest a mix of forces leading to higher inflation headline. Economists, however, still believe that a collapse in demand will eventually lead to deflationary pressures overwhelming any supply-driven inflation.

“As the forward and backward linkages of economic activity are gradually repaired, the supply shock will likely fade while the demand shock will remain, pushing core inflation lower,” said Pranjul Bhandari, chief India economist at HSBC.

Sonal Varma, chief India economist at Nomura, said, “We expect elevated inflation to be transitory.” As supply-chains are restored and demand remains weak, "we expect inflation to fall sharply to average 2.5-3.0% year-on-year in the second half", Varma said.

Inflation Data: Mix of ‘Noise And Signal’

Economists pointed to mixed signals from the headline retail inflation data for the April-June period. The government stayed away from releasing headline CPI data for April and May but released June data on Monday. It also released imputed index data for the previous two months.

This data suggested supply disruption led price pressures:

  • In April, the month of the strictest lockdown, the Consumer Price Index rose to 151.4 from 148.6 in March. CPI inflation rose 7.22% in April.
  • In May, the index eased to 150.9, rising 6.27% on an annual basis.
  • In June, the index was at 151.6, indicating a rise of 6.09% on an annual basis.

Inflation in rural areas was higher through the first quarter, led by higher food prices. Rural inflation in June was at 6.2% compared to 5.9% in urban areas. The Consumer Price Index, taken to rule out the base effect, too, rose to 151.6 in June from 148.6 before the lockdown in March.

Aditi Nayar, principal economist at ICRA, said retail inflation in June was higher than the level in March, when the lockdown was first imposed, challenging the view that demand destruction would cool inflation despite the supply-side hiccups.

According to Bhandari, April to June inflation came in much higher than expected, signaling a large pandemic-led supply shock. The spike was seen across all the main sub-sectors.

The spike in prices of food articles was notable and also understandable.

The food and beverage index rose to 154 in April from 148.9 in March. It eased marginally in May, only to tick higher in June. Meat, oils, pulses saw elevated inflation but perishables like vegetables and fruits did not.

That fed in to the higher headline inflation.

“The surge in headline inflation from 5.8% in March to 7.2% in April prima facie seems to largely reflect lockdown-related supply side shocks. Existing data had already revealed a sharp increase in food and beverages inflation driven by higher prices across most food categories,” said Varma.

Why Did Core Inflation Rise?

The perplexing part of the data was the increase in core inflation. With demand down sharply, core inflation, which excludes volatile food and energy, should have slipped. It didn’t.

In April and May, core inflation remained elevated at 4.7% and 4.9% respectively, according to Rahul Bajoria, chief India economist at Barclays. It remained at 4.9% in June.

Varma said this might be because of the way the data for April and May was imputed. “For a majority of the core categories for which data was previously unavailable, the trend in headline CPI has been used to extrapolate the indices forward from March levels,” said Varma, adding that this may have led to higher food-driven headline inflation reflecting in the data for core inflation.

But it may not all be noise. For instance, higher duties in some cases and increased transportation costs to compensate for the lack of return cargo during a trip may have fed into higher inflation in some categories.

Most Still Expect Inflation To Ease

The higher prints on headline inflation follow an increase in inflation expectations, which had left economists perplexed.

Abhiman Das, RBI chair professor for Finance and Economics at IIM-Ahmedabad, said the figures vindicate the results borne out by the Business Inflation Expectations Survey since March 2020, which showed an increase in headline inflation. One-year ahead business inflation expectations in March 2020 had shot up sharply to 4.57% from 3.85% reported in February 2020. In the survey’s latest round for May as well, they remained over 4%.

The RBI-conducted household inflation expectation survey had also shown an increase in expectations. Both the three-month ahead and the one-year ahead surveys showed an increase between the March and May rounds.

Still, the wide output gap ⁠— the difference between actual output and potential output ⁠— is likely to overwhelm any supply disruptions.

“Overall, with real GDP expected to contract 6.3% in FY21 and with sustaining negative output gap, core inflation is only likely to move lower. On the non-core side, food inflation is expected to remain moderate supported by a robust start to kharif sowing, expected good monsoon and the government holding significant buffer stocks,” said IDFC First Bank economists in a note.