Core inflation dipping for good?

Core inflation is calculated from the Consumer Price Index (CPI) excluding more volatile components such as food and fuel and reflects underlying price dynamics in the economy.

Bloomberg data showed that core inflation eased sharply to an 18-month low (yoy) of 5.95% in March. This is the third consecutive month of decline in the measurement. This decline in core inflation was driven by a significant reduction in prices of discretionary spending components such as clothing and footwear, household goods and services, and entertainment and personal care items.

The underlying dynamics show that some factors are at work. First, the impact of RBI’s 250 basis point rate hike since May has started showing. Monetary tightening compresses aggregate demand, reduces economic activity, and eases price pressures in the economy. That is what is going on now leading to softening of core inflation. Care Edge Ratings expects “core inflation to moderate gradually as the impact of previous rate hikes takes effect.”

Second, global commodity prices have come down significantly in the last few months. International crude oil prices (Brent contract) were trading below $80 a barrel in March as against over $100 a barrel during the same time last year. This has brought down inflation not only in the fuel and commodity components but also in the core basket through its indirect second round effect, particularly on manufactured goods. A similar trend is seen in the Wholesale Price Index inflation data released this week, where inflation in manufactured products fell to -0.77% year-on-year in March.

Third, through last year, solid consumption demand post-Covid enabled significant pass-through of input cost pressures to end consumers thereby boosting profit margins. But it may lose momentum due to gradual easing of pent-up demand and monetary tightening. Along with demand-pull pressures, cost-push inflation also appears to be easing. With the slowdown in economic momentum, the trend may continue.

To be sure, underlying factors suggest that the easing trend in core inflation may persist, especially capped by softening demand conditions and a potentially capped global growth in commodity prices this year. Besides, inflation expectations of households have fallen, shows the latest RBI survey. The average rate for households’ current perception of inflation fell to 8.9% year-on-year in March from 9.6% year-on-year in January.

The easing dynamics of inflation could be a much-needed diversion for monetary policy. The RBI has, from time to time, expressed concern about the sticky nature of core inflation and the need to break this persistence. The early signs that this stickiness is waning bring optimism.

The RBI paused its rate-hike spree in April, while focusing on housing returns to assess the impact of hikes made so far. “It is a strategic pause and not a pivot,” the governor said in the MPC minutes. However, a sustained reduction in core inflation, something over which monetary policy has maximum control, could tilt the balance more in favor of a pivot. The underlying macro provides reassuring signals that core inflation may now be turning south. This could help keep RBI rate hikes at bay, and raise hopes of an end to the rate hike cycle.