RaboResearch - Economic Research

India’s worrying inflation dynamics

Economic Report


Also published on Bloomberg/Quint, September 25, 2020

  • India’s economy has been facing stubbornly high inflation for over almost one year now
  • Food inflation has been the main reason behind the rapid rise in inflation. Core inflation has been higher than expected as well, caused by disrupted supply chains related to local lockdowns
  • Inflation is expected to come down on the back of lower food prices, but we believe the downward inflation trajectory will be short-lived. A combination of factors, such as higher oil prices, global inflation and a closing output gap will result in higher inflationary pressure by the beginning of 2021
  • Given the explicit inflation mandate of the Reserve Bank of India and the importance of the central bank’s credibility, the Monetary Policy Committee will likely remain reluctant to cut its policy rates

My two nephews (11 and 8 years old) desperately wanted a Nintendo Switch when it came to the market. The gaming console does not come cheap, and for over two years they saved all their pocket money and skipped birthday and Christmas presents in exchange for a monetary contribution to the Switch kitty. In April 2020, the boys had finally saved up enough money to purchase the Switch, but their enthusiasm quickly faded when they found out its price had risen by more than 25%. Supply-side issues due to COVID-19 combined with a fast pickup in demand were the root causes of the price surge. My nephews were left with two choices: continue saving or wait for prices to come down. The bottom-line: fast-rising prices make people miserable.

India’s high inflation

India is also experiencing stubbornly high inflation, meaning that the average price level is structurally increasing. The CPI print for August came in at 6.7% (YoY), which means that over the last nine months (with the exception of April) inflation has hovered above the 6% upper band inflation target range of the Reserve Bank of India (RBI). This raises questions such as: is the current high inflation transitory or structural? What can we expect going forward? And what policy course should the Monetary Policy Committee (MPC) set? In this opinion article, we take a deep dive into India’s inflation dynamics.

Cause I: Food inflation

Food inflation has been the main cause behind the rapid rise in inflation since August 2019 (Figure 1). Partly, this was due to unfavorable base effects related to waning food inflation in H2 2018. More importantly, prices of vegetables especially (e.g. onions and garlic) were pushed up from failed crop harvests related to the delayed and disrupted 2019 monsoon, which led to drought and erratic rains (Figure 2).

Figure 1: Inflation remains stubbornly high
Figure 1: Inflation remains stubbornly highSource: Macrobond, RaboResearch, RBI, Indian Ministry of Statistics & Programme Implementation (MoS&PI)
Figure 2: Breakdown of food inflation
Figure 2: Breakdown of food inflationSource: Macrobond, RaboResearch, RBI, Indian Ministry of Statistics & Programme Implementation (MoS&PI)

Even though vegetable prices have come down since the beginning of 2020, price pressure on other food items (meat and fish, oils, cereals, etc.) has picked up and kept food inflation elevated over the last couple of months.

Cause II: Elevated core inflation

Figure 3: Elevation inflation on products hit by COVID
Figure 3: Elevation inflation on products hit by COVIDSource: Macrobond, RaboResearch, RBI, Indian Ministry of Statistics & Programme Implementation (MoS&PI)

Core inflation rose as well (see Figure 1), despite an unprecedented -23.9% contraction of the economy in Q1. During an economic slowdown, lower demand for goods and services normally leads to lower price pressure, but the opposite is true for some goods in the COVID-19 crisis. Supply chain disruptions due to local lockdowns in India have resulted in supply bottlenecks and pushed up costs for manufacturers and retailers, which generally lead to price increases. Sectors that have been hit hardest by COVID-19 like transportation and hotels have begun propping up prices (Figure 3). Moreover, a shift towards working from home has also caused price disruptions to certain items. For example, not many people are eager to buy a tie right now, but they may be looking for a rug to tie the room together to make working from home just a bit more pleasant.

Looking forward: Any relief?

So, what’s in store? With respect to food inflation, the impact of unfavorable base effects is expected to wear off in September and October. Moreover, the monsoon produced 25% more precipitation in 2020 than the long-term average, which will result in lower food prices and is expected to push headline inflation slightly below 6% in the upcoming months (Figure 3). Lower food prices are good news for the poorer part of the population and will be welcomed by the authorities as well.

Sharp pickup expected in Q2 of 2021

We believe the downward inflation trajectory will be only short-lived though. A combination of factors will cause inflationary pressure to start to build again by the beginning of 2021, peaking in Q2 to 7.4%. First, oil prices are expected to show a sharp increase in Q1 (measured on a YoY basis), moving to 50 USD/bbl. More generally, we foresee global inflation picking up next year due to a recovery of global economic activity, resulting in higher import prices and partially into India’s domestic inflation.[1] Finally, we expect India’s economic recovery to gain traction in Q1 2021, leading to upward pressure on core inflation.

Breakout box: How to forecast inflation?

To forecast inflation for the Indian economy we use an improved version of our two-equation model, which integrates an adjusted Taylor Rule (to forecast the policy rate) with the Phillips Curve (to forecast inflation). The catch of this two-equation modelling approach is that inflationary developments and policy rates decisions are mutually dependent. In the inflation model, we have included explanatory factors such as: 1) the output gap to measure the amount of slack in the economy, 2) monthly rainfall to gauge the impact of the monsoon on food prices, 3) the exchange rate and global price dynamics which determine the amount of import inflation, and 4) real money growth (M3 as a ratio of trended real GDP) and the repo rate which accelerate the impact of monetary policy.

Long-term developments

Inflation woes are not just problematic in the short to medium term but could pose an even bigger problem in the longer term. Inflation could exceed 8% in 2023 (Figure 4). As colleagues Stefan Koopman and Elwin de Groot argue in this Report, the rise of China within global trade should be regarded as a supply shock, resulting in significant downward pressure on global prices. This has especially played an important role in the downward price dynamics in developed economies, but it can also be argued that other EMs, such as India, have also been exposed partially to the China export supply shock (see Figure 5).

Figure 4: Inflation is expected to pick up in 2021
Figure 4: Inflation is expected to pick up in 2021Source: Macrobond, RaboResearch, RBI, Indian Ministry of Statistics & Programme Implementation (MoS&PI)
Figure 5: China’s supply shock
Figure 5: China’s supply shockSource: RaboResearch, Macrobond, IMF DOTS

Against the backdrop of increasing geopolitical stress and supply chain vulnerability exposed by COVID-19, firms are increasingly re-evaluating the trade-off between operational efficiency and operational resilience. Many governments are even actively stimulating companies to diversify and adopt a so-called “China + 1 strategy.” Firms already have been moving supply chains away from China, and we expect this trend to accelerate in the coming years. China being phased out of the global trade equation might also result in upward pressure on global prices, even in India.

Secondly, governments around the globe have pumped enormous amounts of fiscal stimulus into the global economy. Fiscal support in the US is more than 14% of GDP and even Germany, a country obsessed with budget balance and proud of its Schwarze Null policy, has been splurging (with a fiscal deficit of 8.4% of GDP). Fiscal policies are better suited than monetary policy to directly inject money into the real economy. But these substantial fiscal packages, in combination with excess global liquidity sloshing around, could result in a dangerous inflationary cocktail when the recovery of the economy reaches an advanced stage or even begins to overheat. In that case, the central bank in India should act quickly to prevent becoming caught up in a potential global inflationary spiral.

Monetary policy headaches

Figure 6: Fiscal woes on the horizon
Figure 6: Fiscal woes on the horizonSource: RaboResearch based on Indian Ministry of Statistics & Programme Implementation (MoS&PI), Indian Ministry of Finance, RBI, IMF. Note: these are calendar years

Speaking of the central bank, the current stagflation[2] situation in India must surely be giving governor Shaktikanta Das and his fellow member of the Monetary Policy Committee (MPC) a headache. The Indian economy is in dire straits and desperately needs more fiscal and monetary stimulus. However, the government does not have room for a third fiscal stimulus package. In our calculations, the 20 lakh crore package and severe crunch of the economy will converge to lead to a severe deterioration of the fiscal deficit: -8.1% in FY20/21 and -6.5% in FY 21/22 (Figure 6).

Against the backdrop of deteriorating fiscal metrics, the central bank will probably have to do the heavy lifting. However, given the explicit inflation mandate of the RBI, the inflation target range of between 2% and 6%, and the importance of the central bank's credibility, the MPC will likely remain reluctant to cut its policy rates in October. In fact, if our inflation projections are correct, the RBI might be forced to even start hiking policy rates in Q1 2021.

Given the gridlock on both fiscal and monetary policy, cries have been growing louder to resort to unconventional monetary policymaking, such as monetary finance or Quantitative Easing (QE). In this BBG/Quint op-ed we argued strongly against India’s adoption of these polices, as it could cause inflation to spiral completely out of control. With domestic rupee liquidity already elevated, the RBI should even be careful to resort to large-scale open market operations (OMO) to buy bonds.

How to escape this policy dilemma?

The long and short of it: Indian policymakers will be hard pressed to stimulate the economy and simultaneously keep inflation in check, especially given the institutional framework of an open capital market and the free-floating INR. Instead, the Modi government could use the sense of urgency created by the corona crisis to start strengthening the fundamentals of the Indian economy, a strategy it is already actively pursuing. Some important steps have been made with the new agricultural and trade bills that have been passed in Lok Sabha very recently. Moreover, the government is pushing ahead with its reforms of labor market laws.

At the same time, much remains to be done on for instance land reforms and on formalizing the economy. The formal labor participation rate currently stands at 40%, which is very low compared to India’s emerging market peers. And as long as India's tax base remains small, the government won’t have the financial means to conduct proper fiscal policymaking. Moreover, the banking sector is still in the shackles—and even after the landmark Insolvency and Bankruptcy Act, we have not seen much action by the government and RBI. Finally, policymakers should focus on improving India’s educational system and stimulating potential growth, as we have previously advocated (see here).

Improving India’s economic fundamentals would not only support India’s productivity growth going forward but would also bolster India’s attractiveness as investment destination. We have argued that India tops the list of emerging markets which might benefit from businesses exiting China (taking into account market size). If India were to become the new global manufacturing hub, it would generate jobs and investment on Indian soil, strengthen India’s knowledge base and innovative capacity, and lower the domestic inflation risk. Within this context it is not unthinkable that India could also become an important player in the diversification of game console manufacturing, which in turn, would support supply chain resilience. Should that happen, I know of at least two boys who will be thrilled.


[1] In our inflation model, a 1% rise in global prices results in 0.8 domestic inflation points.

[2] Stagflation is a term economist often use to indicate a phase of stagnating or contracting output in combination with high inflation.

Hugo Erken
RaboResearch RaboResearch Netherlands, Economics and Sustainability Rabobank KEO
+31 6 2223 1650

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