The monsoon-food inflation myth: Just check out past data

By Sonal Varma & Neha Saraf
As is a ritual every year, a lot of hopes are yet again pinned on the resumption of a normal monsoon in 2016. After two years of deficient rainfall, the India Meteorological Department’s projection of above normal rains has led to hopes that food inflation will fall. Evidence on this is sparse, though. In the last 15 years, the correlation between monsoon rainfall (percentage deviation from normal) and food price inflation is a lowly 0.14 (ideally this should be negative!).

Of the last eight episodes of normal and above-normal monsoon, only two (FY04 and FY06) saw food inflation of under 5%, while in five it was over 8%.

Counter factually, of the last seven episodes of below-normal rains, three still had food inflation of under 5%. In fact, we find two counterintuitive trends. First, since FY02 the average food price inflation in years with below-normal monsoons has been lower at 6.5%, as compared to normal monsoon years at 7.6%. Second, food price inflation is more dispersed (high inflation across multiple categories) during periods of normal/above normal rains (compared with periods of below-normal rains).

So if not rains, what drives food inflation in India?

Using a regression analysis we find that there are four key drivers of food inflation in India. First, rural wages are very important, which is not surprising since human labour accounts for 25-35% of the total cost of cultivation of crops such as rice and wheat. Hence, periods of low rural wage growth suppresses food price inflation from both the demand (weak rural demand) and supply (lower input costs) side.

The three below-normal monsoon years (FY02, FY03 and FY05) with sub-5% food price inflation also witnessed sub-5% rural wage growth.

Second, minimum support prices (MSP) directly feed into food inflation by forming a floor for wholesale food prices and indirectly by impacting inflation expectations, rural wages and by boosting rural terms of trade. In the last two years, despite weak monsoons, cereals inflation has been low at 3.5% as the government has limited MSP hikes to 2.5-4.0%.

Third, other agriculture input costs, such as diesel, electricity, pesticides and agricultural machinery are also important.

And fourth, global food prices are important because of their influence on products that India imports (sugar and edible oil) and because international prices are one of the factors used to determine MSPs of crops. Of these four factors, rural wages and MSP are the most important.

We estimate that every 10% increase in rural wages pushes up CPI food inflation by about 3 percentage points (pp); every 10% rise in MSP raises CPI food inflation by 2.5pp. In contrast, every 10% rise in global food prices pushes up domestic food price inflation by just 0.36pp.

In the last two fiscal years, prudent MSP hikes, a sharp deceleration in rural wage growth and lower global food prices have helped lower food inflation, despite two bad monsoons. However, the sharp fall in these key drivers of food inflation is now behind us, which suggests further downside to food inflation may be limited.

In fact, risks are skewed to the upside. Ongoing public infrastructure construction could raise demand for rural labour and gradually push up wages. Rising diesel prices could incrementally add to agriculture input costs. Similarly, MSP hikes in 2016 are unlikely to be any lower than in the last two years.

Therefore, even if monsoon rains are normal, we do not expect food price inflation to fall from current levels. Rather, it may continue to average at around 5.0-5.5% in FY17. Looking up to the rain gods may not provide any answer.

(Sonal Varma is chief India economist and Neha Saraf is India economist at Nomura)