Factory item prices must cool for lasting inflation relief

In the last three years, rising prices in the manufacturing sector not only outpaced services and the overall CPI, it has fully compensated for the slower price rise before the pandemic. The manufactured goods index is now at a similar level to that of the services price index and overall CPI index. Going ahead, this is the sector to watch.

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

Inflation drivers are typically cost-push factors or supply shocks that temporarily result in high or low price-rise in specific items. If a supply shock is positive, say an improvement in technology or an increase in low-cost imports, then it caps the price rise for that commodity. If a supply shock is negative, such as an uneven and inadequate monsoon for cultivated food, it will result in temporary high inflation in affected articles.

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

In India’s CPI index, food and fuel group CPI data is directly available, but not for manufacturing and services. These two sectors are straddled by sub-groups like transportation, which includes prices of manufactured goods like vehicles and also fares of travel services. Communication has mobile handsets as well as phone bills, a service component. Therefore, the manufacturing and services weights need to 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 weights of 39.05%, 6.84%, 27.37% and 26.74% respectively in the CPI index. Many food items and services in India are mostly non-tradable and their supply is largely restricted to domestic production. Demand for food items, being necessities, is relatively stable. So local supply variations account for volatility in food prices, especially of fruits and vegetables.

From January 2015 to December 2016, food inflation was 5.2%. From January 2017 to February 2020, it was mere 2.6%, while from June 2020 to May 2023, it surged to 5.8%. Given high dependence on monsoon rains and inefficiencies in supply chains, food inflation in India will remain volatile for the foreseeable future.

In both pre- and post-covid periods, services inflation In India was around 5%. While price changes in housing, transportation, education and healthcare have varied, overall services inflation did not change much. Even after lockdowns ended and contact-intensive services opened up, services inflation did not rise much.

Fuel and manufactured goods are tradable and imports at global prices can enhance supply. However, for fuels like electricity and petrol, domestic pricing and tax policies matter. Also, while fuel inflation surged in the post-covid period, especially after the Russia-Ukraine war began, its direct contribution to overall inflation is relatively low, given its low weight in the CPI.

That brings us to the final CPI group: the prices of manufactured goods. In the pre-covid period, these prices rose slowly for several years because of a positive supply shock.

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

During the pre-covid period, the prices of durables such as mobile phones, computers hardly rose. The prices of other durables, such as television sets and refrigerators, also rose slower than services such as education tuition fees. And then, in early 2020, the pandemic hit. There was a reversal in the supply shock, which turned negative. As factories worldwide were shutting down, especially in China, the world’s manufacturing powerhouse, the supply of cheap raw materials and final assembled goods began to fall short, with these shortages becoming acute in many sub-sectors. Pent-up demand in India was unleashed after a couple of months or more of covid compression, by May-end and June 2020, when lockdowns and travel bans began being lifted and relaxed, but this was before pandemic-related supply bottlenecks had been fully resolved. So shortages of manufactured goods persisted, resulting in a surge in prices. Manufacturing inflation was 4.2% between January 2015 and February 2020. From June 2020 to May 2023, it rose much faster than any other group. Manufactured-item prices went up by an annual 7.2%, while those of services increased much slower at 5.1% post-pandemic.

In sum, food and fuel inflation tend to be volatile in India and services inflation remains closer to our inflation target. Only a less rapid rise in the prices of manufactured items can sustainably keep this pressure on overall retail inflation in check.

Updated: 23 Jul 2023, 09:30 PM IST