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Economics

India: Food inflation demand-driven


DBS Group Research 24 January 2011

Our analysis continues to show that food inflation is driven by demandside forces or at least enduring lags in supply. This means it is also nontransient and calls for a monetary policy response. The surge in food inflation in December, however, appears to be driven by temporary supply disruptions and it is important not to over-react to it. Manufacturing ex-food inflation, a proxy for core, rose to 6% (QoQ, saar) in Oct-Dec10, above the RBI comfort level of 5%. Taken together with structurally elevated food inflation, this calls for the RBI to keep its feet on the rate hike pedal a little longer but not slam the monetary brakes. At tomorrows policy meeting, we expect a 25bps hike in the repo and reverse repo rates. We expect this to be followed by a 25bps hike in March and then a 25bps hike in each quarter until Dec11. This should take the repo and reverse repo rates to 7.50% and 6.50% by end-Dec11.

Food inflation structurally high even if adjusted for supply disruptions Supply-adjusted food inflation high
Food inflation has dominated inflation readings in recent years and has come to the fore again with food prices rising by 5% (MoM, sa) in a single month in December. While food prices tend to vacillate with one-off weather events, like other goods, food prices are also driven by genuine demand. In early stages of economic development, higher incomes naturally translate into higher demand for food. Food also accounts for half of the consumption basket in India and thus shapes inflation expectations. As such, unlike central banks of more advanced economies, the Reserve Bank of India (RBI) cannot focus its attention on some measure of core inflation and brush aside food inflation as supply-led.

Table 1: Supply-adjusted food inflation - select years WPI: CPI: Per cap agri food food GDP drop SS adj food (%) (%) (abs %) inflation
(A) (B) (C) avg (A,B)/(C )

Chart 1: Drought years: supply-adj food inflation


Ratio* 14 12 10 8 6 4 2 0 1987/88 1989/90 1995/96 1997/98 2000/01 2004/05 2009/10 F 2010/11 F* Not all food inflation mean the same

1987/88 1989/90 1995/96 1997/98 2000/01 2004/05 2009/10 F 2010/11 F*

11.3 2.2 8.2 2.7 2.8 3.6 15.0 4.0

7.8 4.7 10.9 5.1 1.5 2.2 15.0 8.0

3.9 1.8 3.3 4.9 2.6 1.5 1.3 0.5

2 2 3 1 1 2 12 12

* Assumed production dropped by 0.5% (it actually rose) [1]

*ratio of food inflation and per head agri GDP drop

Ramya (65) 6878 5282 ramya@dbs.com

IN: Food inflation demand-driven January 24, 2011

Chart 2: IN inflation vs rest of Asia


ratio* 2.5 2.0 1.5 1.0 0.5 0.0

Chart 3: IN food inflation vs rest of Asia


ratio* 2.5 2.0 1.5 1.0 0.5 0.0

TW

SG

CN

TH

PH

KR

M Y

ID

PI

CN

ID

W PI

IN

*avg 2010 over avg 2002-09 (one entire cycle) [2]

Our analysis repeatedly shows that food inflation in India is driven to a great extent by demand-side forces or at least enduring weakness in growth in supply relative to demand. One way to estimate the degree of demand-side inflation pressures in food inflation is to calculate the ratio of food inflation and the drop in agriculture GDP in historic drought years (see IN: risk of aggressive tightening, 23 Oct 2009). A higher ratio would imply a greater demand-side component in food inflation pressures. The calculated ratios are indeed very high in the past two years in fact, they are off the charts (Table 1 & Chart 1, previous page). As such, this exercise points unambiguously to demand-side pressures in food inflation [1]. Another approach to gauge the demand-side inflation pressures is to compare inflation in India against that in regional Asian economies after normalising the data for the different historical average inflation rates in these countries. Such a comparison shows that Indias inflation is 1.8 times the average rate that prevailed in the previous business cycle (2002-09) and is much higher than in all other Asian economies save for HK [2]. The picture is even worse for food inflation with Indias food inflation 2.4 times that in the previous cycle, higher than in all other regional economies (Chart 2 & 3, above).

Enduring lags in supply means food inflation is nottransient and demands a monetary policy response

Food production growth is lagging income growth


It should not be surprising that food prices are rising on the back of faster GDP growth. The gap between growth in agricultural output and growth in the rest of the economy is widening. This means per head income growth is increasingly rising faster than per-head growth in agriculture growth (Chart 4). While some may Chart 4: Per capita agriculture GDP and per capita interpret this as a supply-side GDP problem it is supply that is Per cap agri GDP (%) not keeping up with the higher % YoY Per cap GDP growth (%) demand (forcing prices higher 6.0 thus), the bottom line is that this is not a one-off hit to supply 5.0 but a non-transient gap 4.0 between supply and demand. This means food inflation too 3.0 is not-transient and as long as that holds true, it demands 2.0 a monetary policy response (or a decision to live with high 1.0 food inflation rates which 0.0 doesnt appear to be a viable alternative). 1979-1988 1989-1998 1999-2008

IN

*avg 2010 over avg 2002-09 (one entire cycle)

TW
2

TH

PH

KR

SG

IN: Food inflation demand-driven January 24, 2011

Present scenario: core inflation on the rise but Decs food spike supply-led
Coming to the most recent Chart 5: Food inflation by categories bout of inflation that emerged 2004/05=100, nsa in Nov-Dec10, it appears that core inflation is indeed rising 240 Grains and that the headline inflation Pulses 220 rate is distorted by temporary Vegetables disruptions to food supply. 200 An increase in prices of 180 vegetables explains most of the food inflation in December 160 while prices of staples such 140 as grains and pulses have actually fallen in the past year 120 (Chart 5). This narrowly based 100 rise in food inflation betrays weather-related price effects. 80 (one of the ways to estimate Jan-05 Jul-06 Jan-08 Jul-09 core inflation is to calculate the extent to which the pricerise in any inflation index is broad-based). This means, as far as interpreting and responding specifically to the spike in inflation in December goes, it is important to give a greater weight to the ex-food inflation rate and not panic that the economy has overheated. Given the rising growth momentum, core inflation pressures too are on the rise and this is not surprising. Manufacturing ex-food inflation, a proxy for core increased to 8% (MoM, saar) in December and 6% (QoQ, saar) in 4Q10, both above the central banks comfort level of 5%. Taken together with the structurally elevated food inflation (which prevailed even before the spike in December), we think the central bank has to simply keep its feet on the rate hike pedal a little longer but doesnt have to slam the monetary brakes.

December inflation exaggerated by weather; important not to over-react

Monetary policy response to inflation another 100bps of rate hikes


Considering the structural element in food inflation and the current pick up in core-inflation, we added 100bps of rate hikes to the policy rate trajectory last week and revised up the 2010/11 inflation forecast to 8.8% (vs 8% earlier) and 2011/12 forecast to 6.2% (vs 5.6% earlier). At tomorrows policy meeting, we expect a 25bps hike. The rate hikes penciled in now are slightly more than the upside risks we alluded to last year (see India: Higher rates or higher inflation, 26 Oct 2010). This is simply so that higher food inflation, even if driven by supply anomalies, doesnt embed itself in inflation expectations and through that in wage hike expectations. However, expectations of further rate hikes and consequent worries of slower growth have roiled equity markets. We do not expect these fears to be borne out. Our current GDP growth projection of 8.5% already factors in the risks of larger rate hikes in view of the various imbalances building up in the economy but for which our GDP forecasts would have been higher (See IN: A year of rebalancing, 9 Dec 2010). We dont think it should be difficult for the economy to chalk around 8% growth this year a rate that it exceeded by a 1% margin in 2007 when interest rates were at similar levels.

Another 100bps of hikes

Notes:
1. Food production did not even drop in 2010/11. However, even if we assume production dropped by one half of a percentage point, and consider only the lower WPI food-grain inflation, the resulting supply-adjusted inflation measure is as high as in 2009/10 and as such is off the charts. 2. HK saw periods of deflation in 2002-09 which resulted in a low average inflation rate in that period which, in turn, pushes the calculated ratio higher.

IN: Food inflation demand-driven January 24, 2011

Recent research
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29 Jul 10 9 Jul 10 9 Jul 10 7 Jul 10 30 Jun 10 29 Jun 10 28 Jun 10 17 Jun 10 17 Jun 10 25 May 10 20 May 10 19 May 10 14 May 10 13 May 10 7 May 10 30 Apr 10 30 Apr 10

IN policy: Inter-meeting hikes the new norm? 21 Apr 10 ID: Interest Rate Outlook & Strategy IN: Risk of more / earlier hikes KR: Interest Rate Outlook & Strategy SG: More strength to SGD 20 Apr 10 19 Apr 10 16 Apr 10 15 Apr 10

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