Inflation: The contrasting tale of India and the US

Retail inflation is making news in both United States (US) and India. Consumer Price Index (CPI) grew at 5.4% in the US in the month of June 2021. This is the highest monthly inflation in the US in 13 years.

Retail inflation in India was 6.26% in June. June 2021 is the second consecutive month when India’s CPI has stayed above the 6% mark, which is the upper limit of the Reserve Bank of India (RBI)’s tolerance band. The wholesale price index (WPI) in India continued to grow in double digits for the third consecutive month in June.

While, both the US and India are experiencing a high inflation environment, the two are very different. Here is how.

Composition of CPI indices in US and India is different

Retail inflation, by definition, is a measure of change in prices of commodities consumed by the representative household in an economy.

Also Read | Inflation targeting and the Indian economy

The Indian economy differs a great deal from its US counterpart. The former is a lower-middle income economy with a per capita income of $1901; the latter is a high income economy with the largest GDP in the world and a per capita income of $63,544. 39% of India’s CPI basket comprises of food items. This share is just 13.9% in the US CPI. Services account for 58% of the US CPI; in India, it is just 28%.

Base effect is a much bigger factor in US inflation than India

Since the pandemic inflicted a huge disruption to economies across the world, it is important to keep in mind the role of base effect while looking at any statistic which uses year-on-year comparisons.

Base effect is a bigger factor in generating tailwinds for inflation in the US than in India. CPI growth in US in June 2020 was 0.65%, compared to 3.18% in June 2019. This is not the case in India. India’s CPI grew at 6.23% in June 2020 as well.

A useful way to filter out the base effect in inflation indices is to look at its two-year growth rather than the year-on-year growth number. The June 2021 value of CPI index in US and India had grown by 6.07% and 12.88% respectively between June 2019 and June 2021.

What is driving inflation in US and India at the moment?

The first issue here is the importance of core and non-core inflation. Core inflation measures the change in prices of all items in the CPI basket excluding food and fuel. In India, both core and non-core inflation are high at the moment. The respective values were 6.39% and 6.27% in June 2021. These numbers are 4.5% and 8.3% for the US economy.

Food inflation, both in standalone and overall terms, is a much smaller factor in the US than in India. Food prices grew at 5.58% in India and 2.4% in the US in June 2021. Their contribution to overall CPI growth was just 6.42% in the US compared to 32.48% in India. Bulk of the food inflation in India is on account of edible oil and pulses.

Price of petroleum products, which are at a record high, is the other big factor behind the inflationary spike in India. While fuel inflation has also risen in the US, it is largely a base effect. Unlike India, petroleum prices actually went down in the US when crude prices crashed during the pandemic. Weekly retail gasoline price per gallon had fallen by 20% in the last week of June 2020 from $2.715/gallon in June 2019.

What is really driving inflation in the US is a rise in prices of things such as used cars, which experts believe is symptomatic of persisting supply side constraints as demand bounces back in the economy.

“With used cars and trucks accounting for more than one-third of the surge in prices reported by the Labor Department on Tuesday, economists continued to believe that higher inflation was transitory, aligning with Federal Reserve Chair Jerome Powell’s long-standing views”, said a Reuters story.

In contrast, unless the government cuts taxes on petrol-diesel, prices are likely to remain high in India. India is also expected to experience additional inflationary tailwinds as demand for services rises with the economy opening up.

How do markets and economists see inflation?

In today’s world, inflation numbers influence more than an ordinary household’s budget. Thanks to the entrenched inequalities in what is a globalised economy, inflation can have very different consequences for different economies.

Interest rates, capital movements and stock markets are one such example. Real interest rates have been almost zero in advanced countries for quite some time now. This has encouraged capital to move out towards emerging markets in search of better returns. If inflation were to rise in the advanced capitalist world, interest rates will have to rise. Even an expectation of such a development can trigger some sort of capital flight from emerging economies. This is exactly what happened during what is now referred to as the Taper-Tantrum in 2013.

So far markets have not reacted negatively to high inflation in the US markets. Bond yield on benchmark 10-year treasury bonds had increased by four basis points – one basis point is one hundredth of a percentage point – on July 13, the day June inflation data was released. However, this has fallen by 15 basis points between July 13 and July 22, perhaps a result of the US Federal Reserve ruling out any increase in interest rates against what it saw as temporary inflation.

In India, RBI has repeatedly asserted that restoring growth will remain a priority of monetary policy, even though analysts expect that the central bank will have to start withdrawing from the paddle of monetary easing by the end of this year.

“Starting in the December quarter, we expect the RBI to gradually start draining the surplus liquidity, raising the reverse repo rate, and change its stance to neutral. Our real neutral rates analysis suggests that the repo rate will have to be raised by 100bp over time. We expect the RBI to raise the repo rate by 50bp in 2H2022. The remaining 50bp rate hike is likely to follow thereafter (in FY24)”, Pranjul Bhandari, Chief India Economist at HSBC Securities and Capital Markets had said in a note on June 30.

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