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Taking stock of El Nino
In midst of many parts of Asia, Europe and the US experiencing heatwaves, while others face unseasonal heavy rains, the onset of El Nino risks amplifying these volatile weather conditions. The onset has been mild yet far, but expectations are the impact will be more evident in 2H23, through to early 2024. The ENSO indicator i.e., El Nino Southern Oscillation is currently on ‘Alert’ mode as three of the four pre-criteria have been met, which in the past has coincided with an El Niño event around 70% of the time. The other gauge, Indian Ocean Dipole is seen shifting from the mid-point of Neutral-Positive IOD in July to positive by September (see image).
The Indian weather agency has forecasted a ‘normal’ southwest monsoon but is likely to watch the evolving El Nino risks, while the private agency Skymet projects below normal rains. As the risk of strengthening in El Nino looms, the impact could extend from the summer (kharif) to the winter (rabi) crop, with the latter dependent on land moisture, groundwater, and reservoir levels from the summer months.
We track movements in India’s food CPI inflation against the last two EL Nino periods (of which 2015-2016 was more severe) shows that swings were moderate, even if not non-trivial. A key offset for inflation during the adverse El Nino spell in 2015-2016 was lower commodity prices including energy, which helped to keep a lid on non-food pressures.
This year, inflation is at risk in certain pockets including perishables (vegetables), pulses and foodgrains, but the overall situation is expected to be manageable, based on a) adequate reservoir and groundwater levels which will influence the winter crop; b) pre-emptive supply side price management steps including redistribution of inter-state supplies, stepping up imports or export bans to boost domestic stocks, supporting better crop yields, containing hoarders, amongst others; c) conducive terms of trade as energy commodity prices have decelerated from 2022 highs. Impact on rural demand, however, warrants attention with nearly 40% of the population deployed in farm-related activity.
Following up with our earlier note India: Weather watch and impact, the southwest monsoon is underway after a delayed start. Rainfall gained momentum this month, recovering from a deficit in June to a surplus in July but marked by a significant glut in the northwest and deficit in south as well as the east (see map and chart). Notably, the southern and northwest cumulatively account for close to half of the agricultural output. Over the coming weeks, the geographical spread and intensity of the rainfall will dictate progress in sowing of the summer crop and guide arrivals of harvest supplies.
At an aggregate level, summer (kharif) crop sowing activity is marginally lower than the comparable period last year, as of 14-July. The shortfall in the area sown is most significant in rice (-6%), pulses (-13.3%) and cotton (-11.7%) – see chart. This likely reflects the divergence in the geographical spread of the rainfall, as key rice producing states, including Telangana, Andhra Pradesh, Orissa face deficient showers, besides Maharashtra and Karnataka which are amongst the key producers of pulses.
Eyeing ‘W’eather for inflation in the near-term
Reflecting the initial impact of weather-related disruptions in this cycle, Jun23 inflation came in at the higher end of expectations, rising 4.8% yoy vs 4.3% in May, as the food component punched well above its weight. Food accelerated 2.2% mom (nsa), driven by vegetables (12% mom), eggs (5.5%), meat and other protein sources. This offset a slower rise in fuel & light, with core inflation (ex food and fuel) steady at 5.1% yoy and our gauge of core core CPI i.e., excluding food, fuel, transport, and precious metals, easing by 20bp to 5.2% yoy. Urban inflation rose faster than the rural counterpart, likely reflecting additional supply constraints in transportation and logistics.
Besides perishables-driven inflation, foodgrains also warrant attention, particularly rice which is more vulnerable to intensity of the rainfall. There is speculation that most rice exports (all non-Basmati rice) might be banned, which will be in addition to a previous restriction on broken rice imposed last year. The proposed ban, if implemented, is intended to secure domestic supplies, and keep prices in check in midst of uncertain weather conditions. July and August are crucial months, as instances of uneven rainfall could disrupt local sowing and subsequently, final output of the water-intensive crop. A delayed catch-up in rains in the key rice-producing states will also prove to be insufficient to make up for lost yield. Rice inflation has already accelerated from average 6% yoy last year to nearly 12% in June 2023. Meanwhile global benchmark prices have jumped as regional governments are building up inventories in anticipation of El Nino-related disruptions.
Into July, staple vegetable prices continue to climb (10-200%) on sequential terms, with the seasonal buoyancy in this part of the year magnified by the supply shortfall. A 3% month-on-month increase in food inflation in July vs 2.2% in June, along with dissipating base effects, could push headline inflation towards 5.8-6.0% in 3Q23. At the same time, prices also tend to correct sharply in perishables, especially vegetables, helped by short crop cycles and redistribution of existing supplies. Pulling these together, the lift in the quarterly profile for 3Q23 (2QFY) inflation, is expected to be followed by softer readings in 4Q23 and 1Q24 (i.e., 2HFY24).
We revise up our FY24 inflation to 5.3% yoy vs 4.8% earlier and higher than RBI’s official projection at 5.1%. In the latest Monetary Policy Report, the RBI estimated that adverse weather could lead to upward pressure on food, pushing up headline inflation by 50bp above the baseline forecast.
‘Higher for longer’ rates
Strong inflation prints are aligned with the RBI policy committee’s cautious stance on inflation. The anticipated jump in 3Q23 inflation has raised the question on whether the RBI MPC might consider returning to hikes. We expect the official stance to be vigilant on inflation but view the recent spike as seasonal and temporary, thereby not warranting a policy response. Instead, the onus to arrest supply-driven inflation will fall on non-rate measures as discussed earlier in the note. The latest inflation number coupled with hawkish signals from the US Fed validates our view that policy easing is likely to be pushed back to 2024. Policy commentary will retain its hawkish colour by maintaining ‘withdrawal of accommodation’ stance and keep rates on hold to underscore ‘higher for longer’ bias. In the near-term, the real rate buffer could narrow as inflation picks-up again. We delay the start of the rate cutting cycle by a quarter. Come 2024, we expect 100bp of cuts from April, frontrunning the US Fed’s easing by a quarter, based on our baseline assumptions.
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