A Powell-ian Deconstruction of India’s CPI

The biggest known-unknown for economic policymakers around the world is whether upside surprises to inflation are transitory or more enduring. In his Jackson Hole speech, Fed Chairman Powell used a variety of perspectives to argue the U.S. inflation spike appears transitory. What do we find when this ‘Powell Filter’ is applied to India? What does it tell us about whether India’s inflation is transitory or more durable?

One of the many puzzles emanating from Covid-19 has been the juxtaposition of a discernable hit to India’s economic activity and the ostensible slack it has generated, with sticky and elevated inflation over the last 18 months.

If India’s economy grows close to 9% this fiscal year, output will still be about 6% below its pre-pandemic path at the end of the year. This has expectedly generated some labour market slack with the employment-to-population ratio settling about 2 percentage points below pre-pandemic levels in some surveys and demand for MGNREGA – India’s rural unemployment insurance – remaining elevated.

Despite that, headline Consumer Price Index inflation has averaged 6% since the onset of the pandemic, while core inflation has averaged 5.2%. To judge core inflation, we use JPMorgan’s preferred measure ‘core-core’ which nets out gasoline and diesel from the standard core definition.

The dissonance between the hit to activity and elevated inflation has understandably led to a lively debate on whether inflationary pressures are transitory or durable.

Is sticky inflation simply the upshot of repeated lockdowns and will eventually fade as the supply side opens up permanently? Or are emerging inflationary pressures more enduring in nature?

The debate is only likely to get more animated given the expected out-turn of inflation in the coming months. Headline CPI is on course to undershoot the RBI’s trajectory by a 70-80 basis points from July to December, buttressing the view that inflation is settling down as the economy opens up more fully. But core inflation is expected to remain very sticky, buttressing the view that inflation pressures have a more enduring component.

This piece seeks to add to this debate by posing and answering three questions.

• First, when headline and core inflation diverge sharply, which converges to which? Does headline converge to core or the converse?

• Second, using the framework that Fed Chairman Powell used in his Jackson Hole speech to assess U.S. CPI, what can we say about the transience or durability of India’s CPI?

• Third, what is the outlook for goods and services inflation, given the myriad cross-currents (economic reopening, resurgent commodity prices, softer wages) they are currently confronting.

When headline and core inflation diverge sharply, which converges to which?

To understand why this matters, consider this: India’s headline inflation gyrated sharply in 2020 breaching 7% over a year ago late in the year, before falling to 4% in early 2021, then accelerating back above 6% in the summer and softening again in recent months. Meanwhile, core inflation has remained consistently sticky above 5%.

These volatile dynamics are only likely to increase in the coming months.

Softer-than-expected food prices and favorable base effects should push headline inflation below 5% in September and towards 4% in October and November, much below the RBI’s trajectory.

Will core inflation chase after lower headline in the coming months? Or will headline eventually settle back towards sticky core inflation above 5%? The direction of convergence will matter crucially for the outlook.

Casual observation from the chart above would suggest headline typically converges to core. But we undertake a more formal econometric test, which readers can see here.

What do we find?

What this implies is if core inflation remains stuck at 5% or above, headline inflation will eventually settle at that level. If anything, the renewed surge in global commodity and energy prices over the last few weeks create upside risks for core, and therefore headline, through a cost-push channel.

Since headline eventually converges to core, the obvious follow-up to ask is whether core inflation dynamics are transitory or more durable.

In his much-awaited Jackson Hole speech, Fed Chair Powell provided a number of perspectives to argue U.S. core inflation pressures appeared transitory. In particular, he observed:

1. Inflation pressures weren’t broad-based;

2. The narrow group of prices driving inflation appeared to have peaked;

3. Wage trends were consistent with the long-term inflation objective;

4. Longer-term inflation expectations appeared consistent with their inflation target;

5. Global disinflationary forces have contributed to keeping inflation in many advanced economies below their targets.

All this, he argued, suggests a large transitory component to U.S. inflation that can be expected to dissipate with time.

Given the relatively comprehensive overview provided by the Fed Chairman, we ask what such a ‘Powell Filter’ would reveal about the transitory versus enduring nature of India’s inflation?

A. How Broad-Based Is India’s Inflation?

A Pandemic Trim

To assess whether U.S. inflation is being driven by a few outliers or is more broad-based, Chairman Powell relied on ‘trimmed-mean’ inflation estimates (computed by the Dallas Fed) which strip out items with the highest and lowest inflation, so as to understand how the core of the basket is evolving.

Trimmed-mean estimates in the U.S. still show inflation close to 2%, which is what gave the chairman comfort.

In a similar vein, we create a ‘pandemic-trimmed mean’ for India, eliminating outliers on both sides. Because of the unprecedented nature of the pandemic, with sudden and severe supply shocks that fade over time, the approach we use is to estimate the average monthly increase of India’s CPI basket (~300 items ) over that of the pandemic period. We then trim out 20% of items with the lowest and highest average sequential inflation rates. This preserves the same basket throughout the period and precludes the need to use a first approximation as in the standard trimmed mean computation.

In India’s case, we find trimmed-mean measures have been accelerating over the last two years and have eventually converged with core inflation above 5% as shown in the figure below.

A Diffusion Index

A second approach we use to assess inflation breadth is to create a diffusion index. Here we ask what percent of items in the basket are increasing sequentially at an annualized pace exceeding 4% (India’s inflation target) every month?

As the chart below reveals, the diffusion index has steadily increased in recent years, also suggesting broadening inflationary pressures.

A Disproportionality Index

A third approach is to ask whether inflation is particularly skewed at the top?

Has the percentage of inflation accounted for by, say the top 20% of high-inflation items, increased markedly during the pandemic? Even as this disproportionality index has increased over the last year, it remains close to its five-year average, suggesting inflation pressures aren’t necessarily overly concentrated or skewed.

B. How Are Inflation Expectations Evolving?

Continuing with the Powell-ian filter, we assess the evolution of inflation expectations of households and businesses.

Admittedly, this relies on shorter-run (one-year-ahead) expectations given the lack of data for the longer-run. That caveat notwithstanding, one-year-ahead inflation expectations of households—which already were rising in the run-up to the pandemic—have increased by about 200 basis points over the pandemic.

Business inflation expectations—as computed by IIM Ahmedabad—have also been steadily increasing in recent years and are about 170 basis points higher from before the pandemic.

Rising inflationary expectations could potentially explain the simultaneous existence of slack and sticky inflation—a topic to which we return later.

C. Wage And Cost Pressures

Finally, how are cost and wage pressures evolving?

Fed Chair Powell took comfort from wages firming in a manner consistent with the Federal Open Market Committee’s inflation target. What about India? In the absence of broad-based wage data, we rely on the evolution of rural wages and the wage costs of listed companies (which, admittedly, are a small fraction of the overall labor market, but the best proxy we have for the formal sector).

We find that while the formal-sector wage bill is rebounding after a sharp hit, it’s just approaching growth rates seen before the pandemic and still running below average wage growth in recent years.

By contrast, rural wages rose during the first lockdown reflecting both increases in administered wages and labour shortages. As the economy has normalised, however, rural wage momentum has softened.

Industrial raw material costs have risen in India’s Wholesale Price Index till August. This does not yet incorporate the September surge in energy and commodity prices.

Therefore, even though wage inflation may appear generally soft, input cost pressures emanating from commodities are squeezing margins and potentially creating a powerful impulse for firms to raise output prices, especially as the economy opens up and demand recovers.

Since the onset of the pandemic, India’s inflation has been underpinned by goods prices, like around the world. Disproportionate demand for goods in conjunction with supply bottlenecks and input price pressures likely explain price dynamics. In comparison, services inflation has been much softer.

That said, as vaccination rates rise and the services economy progressively opens up, services inflation is expected to rise. In particular, to the extent that some services have been grossly under-consumed over the last 18 months, demand for them could be relatively price-inelastic, creating more opportunities for firms to raise prices and recover the losses of the last two years.

As in other parts of Asia, therefore, we would expect accelerating services inflation to accompany re-openings.

The hope and expectation is that expenditure switching from goods to services would enable goods disinflation that could help offset the rise in services. But if cost-push pressures in the goods industry are getting more acute, the anticipated goods disinflation risks getting impeded, even as services accelerate. Ultimately, where goods and services intersect will have a crucial bearing on the outlook.

All told, a ‘Powell-ian Filter’ (breadth, expectations, cost pressures) suggests India’s inflation is characterised by a more durable component. This, then, raises the bigger question: why is inflation so sticky if the output gap is so large?

In an augmented Phillips Curve, inflation is a function of expectations, slack, and cost pressures.

Are firming inflation expectations and cost-push pressures responsible for elevated inflation, as would seem evident at first? Or are more profound industrial structure changes underway on account of the pandemic? Given the informality of the economy, has the supply curve been impacted more than believed? Is the output gap therefore smaller than believed? Has increased market share of larger organized-sector firms in the pandemic increased pricing power? Are these industrial changes underpinning sticky inflation despite a discernable impact on activity?

It’s too early to postulate which of these factors, and in what combination, may currently be at play. Eventually, however, distinguishing between these hypotheses is crucial so that policy can be calibrated appropriately for a post-pandemic world.

Sajjid Chinoy, Toshi Jain and Gopal Kumar are members of JPMorgan’s research team.

The views expressed here are those of the authors, and do not necessarily represent the views of BloombergQuint or its editorial team.