Inflation at 5% by Mar ’23, stagflation more likely than recession: SBI

Inflation is likely to end up closer to 5% by March next year, with the downward trend in price rise attributable to supply side factors auguring well for the economic indicator going forward, says a note by the State Bank of India (SBI).

In its recent Ecowrap report, the lender notes that supply side inflation is currently driving 64% of headline inflation in India, while the remaining 36% is due to demand-led factors.

“Our results show that supply side factors are currently responsible for almost two-third of the current elevated level of CPI inflation. This in part reflects supply constraints from continued global supply disruptions related to the pandemic and the war in Ukraine. Demand factors contribute only one-third to CPI inflation,” the SBI report says.

In India, CPI inflation attributable to supply side factors started moving up after September 2021 even as demand-led CPI remained more or less constant. Both started moving together after February 22 with the start of the Russia-Ukraine conflict.

“However in recent months, demand-led CPI inflation has moved up a bit, while supply-led CPI inflation continues to moderate. Clearly, the RBI (Reserve Bank of India) may have to raise rates further though, the clear downward trend in inflation attributable to supply side factors bodes quite well for inflation trajectory going forward,” the report notes.

Core inflation has trended down from its peak in April, on account of a fall in contribution of transport and communication from 1.7% in April to 1.1% in June. This fall in core CPI is largely the product of fall in demand owing to the lagged effect of high inflation in the past months, SBI says.

With major states such as Maharashtra, which contributed 95 bps to all India CPI in June, expected to announce a cut in value-added tax (VAT) on fuel, it is expected that core inflation may correct further as the decline in fuel prices is passed on to consumers in subsequent months along with correction in global prices of commodities.

Global commodity prices, including crude oil rates, skyrocketed as the Russia-Ukraine war throttled supply of raw materials, which was already restricted by logistical logjams, bad weather and other disruptions. However, in recent weeks, this situation has improved. Crude oil is trading at around $100 a barrel, compared to March Brent crude level of $128 per barrel. Copper has dropped below $8,000 a tonne for the first time in 18 months, while metals in general have fallen by 10-60% since their 52-week high. Agricultural commodity prices are also back at pre-war levels.

Meanwhile, prices for several goods and services will rise from July 18, with the Goods and Services Tax (GST) Council increasing tax rates to address inverted duty structures and withdrawing some exemptions. As per SBI’s calculation though, the additional impact of GST rates increase on CPI inflation will be in the range of 15-20 bps only.

“The problem, however, lies with central banks in developed economies that should have normalised monetary policy from mid 2021 itself and did clearly miss the bus... the wide gap between the job vacancy rate and unemployment rate (currently at 3.3%) in the U.S. currently indicate a strong labour market. This will translate into higher nominal wages. This in turn might create a wage-price spiral,” SBI says.

“Hence a moderation in commodity prices would not be enough to halt rising inflation. The fear arises that spiralling inflation and an aggressive monetary policy tightening cycle may lead to the recession particularly in the U.S. economy,” it further adds.

The Ecowrap report, however, claims that recessionary fears are unfounded and a prolonged stagflation is more likely.

“Historical analysis done by Alan Blinder indicates that out of 11 episodes of high inflation/monetary tightening in the U.S., seven of them were arguably “pretty soft”, and three of them never had the intention of making the landing soft. And hence in the current situation the risk of a recession is only 20-30%; instead the chance of prolonged stagflation seems more,” it projects.