Who wrote this article?

Deepak Shenoy, Capitalmind's research team.

What does the "Factors that impact inflation or vice versa" section say?

Fiscal Deficit : A high fiscal deficit indicates high government spending but not enough revenue. That will cause inflation through both higher demand (high government spending) and low supply (credit becomes difficult to get since people will prefer to lend to the Currency Exchange rate: If the rupee gets weak, stuff we import gets costlier in rupees. Our biggest import is oil. If oil prices go up in rupee, everything we buy becomes more expensive. There’s a tipping point at which time we will have to reduce our use of oil, but it only will happen if the government passes through the oil price hikes to us. Money Supply Madness: Eventually, Inflation is a result of more money chasing the same goods. If the total number of rupees increases faster than the number of goods being produced, we will automatically pay more for the same goods. Initially we may pay the same amount and save the rest, but eventually when the savings rate stops growing, we’ll just pay more. The only way to stop this madness is for the RBI to curb liquidity (but it is definitelynot doing that). The RBI has, in effect, provided a quantitative easing in the nature of increasing money supply by 16% a year since 1997. That will undoubtedly cause inflation, and yes, the savings rate is indeed dropping now. Interest rates: One way to curb inflation is to increase interest rates and make money more expensive. Volcker did that in the US during the 70s, when the US saw persistent high inflation, mostly because of the oil price spike and high money supply growth. The 10 year bond went to 16%+ and there were two recessions before inflation came under control in 1982 - and it has been benign since.

Macronomics: The Whopping Inflation Put In Context; Mr. Diesel Did It!

18 Dec 2013Deepak Shenoy11 min read

Quick Facts

What is "Macronomics: The Whopping Inflation Put In Context; Mr. Diesel Did It!" about?
What category is this article in?: Premium
Who wrote this article?: Deepak Shenoy, Capitalmind's research team.
When was this article published?: Published 18 December 2013.
How long does this article take to read?: 11 min read
What topics does this article cover?: Inflation
What does the "What this post tells you:" section say?: [level-capmind-pro]
What does the "Wholesale Price Inflation...." section say?: ...came in on Monday, at 7.52%, the highest in fourteen months.
What does the "Month-on-Month Inflation" section say?: Now let’s look instead at “Month on Month” inflation. That means, let’s compare November with October, October with September and so on.
What does the "Contributors" section say?: What “Caused” the 7.52% number? Let’s see:
What does the "Deconstructing Inflation" section say?: Inflation is simply a measure of how much more you pay for the same thing. To measure how inflation affects you, you’d have to consider every item you would regularly need to buy and track their prices.
What does the "Price Indexes" section say?: There are at least four price indexes to measure inflation in India. The Wholesale Price Index is released by the Office of the Economic Adviser, once a month (typically around the 15th, for the previous month). Wholesale prices include cost of produced goods and the basket has over 700 different elements.
What does the "The GDP Deflator: Another way of looking at Inflation" section say?: Another way to measure inflation is to look at the difference between the real and nominal GDP numbers. The “deflator” tell us about how much prices have impacted us. The nominal GDP is simply what a country sees as “added value” in current prices. The “real” GDP is what it would be in money of a base year, so that you remove the impact of inflation.
What does the "Factors that impact inflation or vice versa" section say?: Fiscal Deficit : A high fiscal deficit indicates high government spending but not enough revenue. That will cause inflation through both higher demand (high government spending) and low supply (credit becomes difficult to get since people will prefer to lend to the Currency Exchange rate: If the rupee gets weak, stuff we import gets costlier in rupees. Our biggest import is oil. If oil prices go up in rupee, everything we buy becomes more expensive. There’s a tipping point at which time we will have to reduce our use of oil, but it only will happen if the government passes through the oil price hikes to us. Money Supply Madness: Eventually, Inflation is a result of more money chasing the same goods. If the total number of rupees increases faster than the number of goods being produced, we will automatically pay more for the same goods. Initially we may pay the same amount and save the rest, but eventually when the savings rate stops growing, we’ll just pay more. The only way to stop this madness is for the RBI to curb liquidity (but it is definitelynot doing that). The RBI has, in effect, provided a quantitative easing in the nature of increasing money supply by 16% a year since 1997. That will undoubtedly cause inflation, and yes, the savings rate is indeed dropping now. Interest rates: One way to curb inflation is to increase interest rates and make money more expensive. Volcker did that in the US during the 70s, when the US saw persistent high inflation, mostly because of the oil price spike and high money supply growth. The 10 year bond went to 16%+ and there were two recessions before inflation came under control in 1982 - and it has been benign since.
What does the "So what’s the point?" section say?: The idea was to introduce the concept of inflation and how it’s measured in India.
What does the "Disclaimer" section say?: Nothing in this newsletter is financial advice and should not be construed as such. Please do not take trading decisions based solely on the matter above; if you do, it is entirely at your own risk without any liability to Capital Mind. This is educational or informational matter only, and is provided as an opinion.

This week, we speak of inflation. Let’s look at the Wholesale Price Index Release.

First, a quick note. Thanks for the tremendous response to Capital Mind Premium! I’ve mentioned on the site that we have extended the Capital Mind Premium 40% discount (Effectively Rs. 5,999) to December 20, 2013 due to many issues with Bank gateways over the weekend.

Do take advantage of this offer if you have not - the discount falls to 20% after December 20, which takes prices to Rs. 7,999.

Now for the meat of the story this week.

What this post tells you:

[level-capmind-pro]

The Wholesale Price Index and Inflation, Year on Year and Month on Month
You wouldn’t know it, but it wasn’t just food, it was Mr Diesel!
Demystifying Inflation Data and 40 year graphs.
How Inflation Affects Us
The Real Point: The rate hike may come but it won’t hurt
The Sectors to look at for the next year are Infra, Power and more.

Wholesale Price Inflation…

…came in on Monday, at 7.52%, the highest in fourteen months.

The Year on Year impact is huge as you can see. And if the green line continues on its upslope, we have a serious problem because the blue line, it flattens out a couple months more ahead of us, so the gap will widen. But there’s a good reason why the green line might not keep going up steeply.

Month-on-Month Inflation

Now let’s look instead at “Month on Month” inflation. That means, let’s compare November with October, October with September and so on.

The Month-On-Month number oscillates a lot so let’s take the three month average to smoothen it out.

When this average goes below zero, Year on Year “headline” inflation falls a few months later. If it goes to 1%, year on year inflation follows in a few months.

We have just seen MoM inflation go up to nearly 1.5% in July/August. This is now visible in Year on Year data today. But if this MoM graph continues downwards, **we should see inflation come off the highs after May 2014 **- which is perfect for a new political party. More on this later.

Component wise - you can see the volatility in food and fuel prices, but not quite so much in manufactured goods:

(Note: This is Month on Month)

Food inflation hasn’t “cycled” below zero (MoM) for a while, and this is a mean reverting process, generally. As prices of vegetables and food falls, we’ll see this go to negative territory.

Note: It is statistically incorrect to just use MoM comparisons. There could be a significant seasonal impact (like Diwali or March-year-end issues) which cause MoM comparisons to be wrong. However, from Ajay Shah’s excellent cycle.in, we see that seasonality is not a big deal in the WPI itself. (though it may be in some of the components). Note though that the site hasn’t been updated in a few months.

Contributors

What “Caused” the 7.52% number? Let’s see:

The biggest culprit was food. But Crude and fuel added quite a bit, as did Electricity (costs went up).

Just 8 items contributed to nearly half of the inflation seen:

As you can see, it wasn’t just food. Diesel was the biggest single contributor to inflation, and the second biggest was electricity. Onions, Tomatoes and Fish were also big culprits.

Deconstructing Inflation

Inflation is simply a measure of how much more you pay for the same thing. To measure how inflation affects you, you’d have to consider every item you would regularly need to buy and track their prices.

There are three ways for inflation to impact us: High Demand and Relatively Low Supply. Even though demand for mobile phones is high, the supply is growing at a larger pace due to advancements in technology. And this causes prices of mobile phone to fall. But that doesn’t happen with food, and with specific kinds of food (like Milk) so prices go up.

For a country, it’s more complex. It has to create a basket of goods that will be a proxy for nearly everybody, and thus determine what kind of inflation people must be feeling. Which gets so complex, that the basket eventually contains a lot of things but no one ever uses that exact basket. Which is why we’ll have Harvesters and Threshers along with Industrial Furnaces in a “basket” that constitutes the Wholesale Price Index.

But given that we don’t have much of a choice, how can we measure Inflation?

Price Indexes

There are at least four price indexes to measure inflation in India. The Wholesale Price Index is released by the Office of the Economic Adviser, once a month (typically around the 15th, for the previous month). Wholesale prices include cost of produced goods and the basket has over 700 different elements.

WPI data exists from 1982, and is indexed to different “base years”. If we merged all of them together and created a singled unified data set, then annual inflation for the last thirty years looks like this:

And then we have the CPI - the Consumer Price Index. The most reliable today is the Consumer Price Index (New) released by the Ministry of Statistics and Program Implementation (MOSPI). This has, unfortunately, a short history (only since Jan 2011). This does have many service elements - and important elements like clothing (retail prices), housing (rents) and financial services.

A longer term history is available through the Ministry of Labour (the Labour Bureau), which publishes three CPI indexes:

The CPI for Industrial Workers (CPI-IW)
The CPI for Agricultural Labourers (CPI-AL)
The CPI for Rural Labourers (CPI-RL)

If this sounds insane, it is.

I don’t know why we have all these indexes. Perhaps someone derives a lot of pleasure in going to rural areas and distinguishing between rural and agricultural labourers and then creating different baskets of goods for each of them. But we have a lot of numbers, all the way back to 1967.

They’re all following the same trajectory.

You’ll notice that while we say Inflation is “high” it’s not really an unprecendented level in all these indexes. And the historians among you might have noticed that inflation fell deeply negative during the Emergency in the mid-70s - a dictatorial presence usually brings some of these illegal activities of hoarding etc. in line.

The GDP Deflator: Another way of looking at Inflation

Another way to measure inflation is to look at the difference between the real and nominal GDP numbers. The “deflator” tell us about how much prices have impacted us. The nominal GDP is simply what a country sees as “added value” in current prices. The “real” GDP is what it would be in money of a base year, so that you remove the impact of inflation.

So if you could produce 10 phones at Rs. 100 each five years back, and today you can produce 25 phones of Rs. 150 each, then the nominal GDP today is: 25 x Rs. 150 = Rs. 3750.

In the same rupees as 5 years back, your phone costed Rs. 100. So your “real” GDP is 25 x Rs. 100 = Rs. 2,500 (in the same price 5 years ago).

Apologies for those who already know this, as it was part of the December 1 post of Macronomics on GDP.

Now the deflator, in this five year period is simply 100 x 3750/2500 = 150. The percentage change in the deflator over time is the effect of inflation.

Factors that impact inflation or vice versa

**Fiscal Deficit : **A high fiscal deficit indicates high government spending but not enough revenue. That will cause inflation through both higher demand (high government spending) and low supply (credit becomes difficult to get since people will prefer to lend to the
**Currency Exchange rate: **If the rupee gets weak, stuff we import gets costlier in rupees. Our biggest import is oil. If oil prices go up in rupee, everything we buy becomes more expensive. There’s a tipping point at which time we will have to reduce our use of oil, but it only will happen if the government passes through the oil price hikes to us.
Money Supply Madness: Eventually, Inflation is a result of more money chasing the same goods. If the total number of rupees increases faster than the number of goods being produced, we will automatically pay more for the same goods. Initially we may pay the same amount and save the rest, but eventually when the savings rate stops growing, we’ll just pay more. The only way to stop this madness is for the RBI to curb liquidity (but it is definitelynot doing that). The RBI has, in effect, provided a quantitative easing in the nature of increasing money supply by 16% a year since 1997. That will undoubtedly cause inflation, and yes, the savings rate is indeed dropping now.
Interest rates: One way to curb inflation is to increase interest rates and make money more expensive. Volcker did that in the US during the 70s, when the US saw persistent high inflation, mostly because of the oil price spike and high money supply growth. The 10 year bond went to 16%+ and there were two recessions before inflation came under control in 1982 - and it has been benign since.

In India there are other factors. Since food is a huge part of our inflation basket, we should produce more food. And we do. But it gets gobbled up by the FCI in the guise of providing “minimum support prices” and stored in large warehouses and left to rot. Farmers who would have otherwise grown vegetables will grow cereals and rice and wheat because the government is stupid enough to buy massive quantities at a large price. (Our warehouses have 2x the amount of stock required, and yet, we buy more).

The APMC acts don’t allow outsiders to easily purchase food items from farmers. The “mandi” has to be involved. This is retrograde and not a free market, and leaves prices in control of a few people.

People are now moving baskets - what was a “staple” (rice, wheat) is now cheap, and people have more money, so they move to demanding pulses and protein foods which are in short supply partly because the supply hasn’t yet reacted to the demand, and mostly because there is no equivalent “MSP” that attracts farmers. (I would rather remove all the subsidies, honestly, instead of adding new ones to make up for this).

So what’s the point?

The idea was to introduce the concept of inflation and how it’s measured in India.

Now for the impact of the inflation numbers.

WPI is at 7.52%
CPI is at 11.24%

With this** there is a good chance we’ll see an interest rate hike**.

A rate hike is not a huge problem. Why? Because what the RBI raises is the overnight repo rate, which is currently 7.75%. It’s not really the operational rate anymore - that would be the term repo rate, which is a 14 day borrowing by banks, rolled over.

This term repo is already at 8%. The 8% is a rate determined by banks who bid, not by the RBI. If the overnight repo rate is raised to 8% (through a 0.25% hike) then it’s not like it’s increasing the borrowing cost of banks by too much. To make a difference, RBI will have to raise rates by 0.5% or more, which, given the weak state of industry and the low manufactured goods inflation, they are loath to do.

If there is a marginal rate hike**, the downward pressure on the market isn’t much**. And we are likely to see low inflation in June/July, looking at the MoM data above. The food price pressures have already eased up (onion prices have fallen and so on).

This means the impact to the market is mostly positive, and we could start seeing a reversal of the rate cycle from June. It would then make sense to start looking at interest rate sensitive stocks, and those that can take debt but shy away due to higher rates. And we’ll have to buy them before the interest rate cycle turns.

We’ll look at some in other premium posts on an individual basis, but the sectors to watch out for are:

Auto ancilliaries (they’ve been beaten up a lot)
Infrastructure stocks (who don’t already have a big problem)
Power companies

In general, I’d also look at Low Debt Companies who can borrow at lower rates.

Risks: A US Taper or another crisis in Europe may change things. A drop in the rupee will definitely hurt inflation and change the equation. As will a political stalemate in the elections.

Disclaimer

Nothing in this newsletter is financial advice and should not be construed as such. Please do not take trading decisions based solely on the matter above; if you do, it is entirely at your own risk without any liability to Capital Mind. This is educational or informational matter only, and is provided as an opinion.

Disclosure: The authors at Capital Mind have positions in the market and some of them may support or contradict the material given above, or may involve a direction derived from independent analysis.

[/level-capmind-pro]

Tagged:Inflation