Factory item prices must come down for lasting relief from inflation

Over the past three years, rising prices in the manufacturing sector not only outpaced services and the overall CPI, but also fully offset the slower price growth before the pandemic. The manufactured goods index is now at the same level as the service price index and the overall CPI index. Going forward, this is an area worth watching.

First, a clarification: This article discusses the drivers and not the causes of inflation. Excess money in the economy for a sufficiently long period of time causes sustained overall inflation.

Inflation drivers are usually cost-push factors or supply shocks that result in temporarily higher or lower price-rises in specific goods. If the supply shock is positive, such as an improvement in technology or an increase in low-cost imports, it limits price increases for that commodity. If the supply shock is negative, such as an uneven and inadequate monsoon for farmed food, it will result in temporary higher inflation in the affected items.

What does the evidence show in terms of inflation drivers since India adopted the inflation-targeting regime?

In the CPI index for India, food and fuel group CPI data is directly available, but not for manufacturing and services. Both of these sectors extend into sub-groups such as transportation, which also includes prices of manufactured goods such as vehicles and fares for travel services. Mobile handset as well as phone bill is a service component in communication. Therefore, the charge on manufacturing and services should be calculated by separating the two.

Data shared by Crisil, which maintains a CPI record that separates manufacturing (including processed food) and services prices, shows that food, fuel, manufacturing (including processed food) and services have a weight of 39.05%, 6.84%, 27.37% and 26.74%, respectively, in the CPI index. Many foods and services in India are mostly non-tradable and their supply is largely limited to domestic production. Being a necessity, the demand for food items is relatively stable. Local supply variations therefore lead to volatility in the prices of food items, especially fruits and vegetables.

Food inflation from January 2015 to December 2016 was 5.2%. It was just 2.6% from January 2017 to February 2020, while it increased to 5.8% from June 2020 to May 2023. Given the high dependence on monsoon rains and inefficiencies in supply chains, food inflation in India will remain volatile in the near term.

In both the pre and post Covid period, service inflation in India was around 5%. While price changes in housing, transportation, education and health care have varied, overall services inflation has not changed much. Even after the end of the lockdown and opening of contact-intensive services, inflation in services did not increase much.

Fuel and manufactured goods are tradable and imports at global prices can increase supply. However, for fuels such as electricity and petrol, domestic pricing and tax policies matter. Further, while fuel inflation rose in the post-Covid period, especially after the start of the Russia-Ukraine war, its direct contribution to overall inflation is relatively small, given its low weight in the CPI.

This brings us to the last CPI group: prices of manufactured goods. In the pre-Covid period, these prices rose gradually over several years due to positive supply shocks.

International trade ensured technological and quality improvements, both in inputs and final goods. Low-cost imports from countries such as China kept imported inflation low, thereby curbing the rise in prices of domestically produced goods.

During the pre-Covid period, the prices of durable goods like mobile phones, computers hardly moved. Prices of other durable goods such as television sets and refrigerators also rose at a slower pace than services such as education tuition fees. And then, in early 2020, came the pandemic. The supply shock reversed, turning negative. As factories were closing around the world, especially in China, the world’s manufacturing powerhouse, the supply of cheap raw materials and final assembled goods began to decline, with shortages becoming severe in many sub-sectors. In late May and into June 2020, when lockdowns and travel restrictions began to be lifted and eased, post-Covid pressure in India peaked for a few months or more, but this was before supply constraints related to the pandemic were fully resolved. Hence there was a shortage of manufactured goods, resulting in a rise in prices. Manufacturing inflation between January 2015 and February 2020 stood at 4.2%. From June 2020 to May 2023, it grew much faster than any other group. Manufactured goods prices increased by an annualized 7.2%, while services prices grew at a much slower rate of 5.1% after the pandemic.

To sum up, food and fuel inflation in India remains volatile and services inflation remains close to our inflation target. Only a less sharp rise in prices of manufactured goods can continue to keep this pressure on overall retail inflation under check.

UPDATE: July 23, 2023, 09:30 PM IST