The weatherman has company. He is no longer the only one to be ridiculed for inaccurate forecasts; inflation experts have joined the ranks. It is not surprising given that the weather forecast has a deep impact on inflation prediction. Even the Reserve Bank of India cannot say which way the wind will blow, literally. Its recent prediction of 5.5 per cent inflation by next March comes with a qualifier—normal monsoon.
Unfortunately, the capricious winds have no regard for the weatherman or economic experts. Compare the first monsoon forecast of 2009 with the end-of-the-season report, and you will know why. The monsoon prediction for this year sounds ominously similar, with a mere 2 per cent difference in expectation offering optimism. So, irrespective of how meticulous the calculation, the inflation rate for the next few months is anybody's guess.
Why the fuss about the precision of forecasters? It is obvious— each weekend trip to the market leaves you with fatter grocery bills, and not because you are consuming more. According to the RBI's Inflation Expectation Survey of Households conducted in March this year, 70.4 per cent of the 4,000 respondents expected food prices to increase in the ensuing three months at a pace higher than the rate of inflation in March.
The WPI figures for April corresponded to this view. While fruits and vegetables became costlier by 6.16 per cent, the prices of pulses and cereals increased by 11.93 per cent and those of eggs, meat and fish by a staggering 32.24 per cent.
It is not just your budget that bleeds because of incorrect inflation assumptions. The impact on your goals is worse. Let's assume you are saving to buy a car after three years; it is worth Rs 5 lakh now. While calculating how much to salt away every month, you assume the annual inflation to be 5 per cent and your investments to grow by 12 per cent every year.
Suppose, however, that the car firm decides to jack up prices by 8 per cent a year due to a spurt in the cost of steel. So, though you have saved diligently, your corpus will fall short of the target by about Rs 51,000 (Rs 6.29-5.78 lakh). Extend this logic to other aspects of your life, such as retirement nest egg, child's education, etc, and you realise why it is important that the inflation forecasters get their numbers right.
Unfortunately, monsoon is not the only unpredictable parameter that they have to grapple with. Global commodity prices, especially oil, can also spring nasty surprises. Crude oil hit a high of $88.94 per barrel between January and April 2010. Steel prices are also rising— they shot up by 17.8 per cent between January and April 2010. This may upset the positive impact of the bumper rabi crop on stabilising food inflation, which registered only a small increase from 16.65 per cent in March to 16.87 per cent in April.
However, the long period of high food prices has already done some damage. "Due to sustained food inflation, wages and general industrial costs rise. As there was a demand slump, the industry did not have the pricing power to pass on the increase in costs to consumers. The situation has changed with the economic recovery. This is why inflation is becoming broad-based," says Ashima Goyal, professor at the Indira Gandhi Institute of Development Research.
The RBI's decision to increase the cash reserve ratio by 25 basis points is expected to contain the spillover by sucking out liquidity from the system. However, as officials at the central bank say, "Associated structural issues also need to be addressed to attend to the problem in the medium term."
Does this mean no one can accurately predict inflation for the next few months? Yes. You will find many an expert making tall claims using his private crystal ball. But such claims are futile if they are conditional. Low inflation hanging by several 'ifs' is hardly a prediction and is not useful to investors.
So how do you incorporate headline inflation in your financial plan? By ignoring it. Don't predict, just prepare for inflation. You won't lose out on much. The Wholesale Price Index (WPI) does not reflect the real price rise faced by urbanites as their consumption pattern is different from the basket of items and weightages used to calculate the WPI. It is like analysing the weather in Shimla to predict rainfall in Delhi simply because the two places are geographically close.
Even the Consumer Price Index, which is aligned more to the urban consumer's spending, does not replicate it entirely. For example, it does not factor in the rise in prices of services, which contribute sizeably to your monthly household bills.
Swapnil Pawar, head of HNI Solutions, Karvy, suggests, "For goals that are about five years away, investors should calculate the future costs individually. For instance, the cost of education is likely to surge faster than headline inflation. On the other hand, marriage expenses will not increase much in this time frame." If you use inflation assumptions as per the trends in specific sectors, you need not panic during phases of high headline inflation as it will be irrelevant to your plan. Most experts think that in the long term, an assumption of 6 per cent annual inflation will keep you on the right track for achieving your goals.
To address the immediate cash crunch, cut back on discretionary expenses like movies and dinners. In addition, keep a 10 per cent buffer in your budget for unforeseen expenses. Make the effort of comparing prices rather than depending solely on the whims of the neighbourhood shopkeeper. Most departmental stores advertise special discount days, which are worth checking out, This seems too simple, but as Pawar points out, "The trends in modern retail can reduce the prices of household items for most families." So don't ignore the obvious.
Will the weatherman be right this time?
2010
First forecast
Quantitatively, the monsoon rains are likely to be 98 per cent of the long period average (LPA), with a model error of ± 5 per cent.
2009
First forecast
Quantitatively, the monsoon rains are likely to be 96 per cent of the long period average, with a model error of ± 5 per cent.
End-of-the-season report
The rainfall for the 2009 season (June-September) in the country was 78 per cent of its LPA. The monthly rainfall was 53 per cent of LPA in June, 96 per cent of LPA in July, 73 per cent of LPA in August and 80 per cent of LPA in September.
Food for thought
Even when general inflation levels have been low, food prices have risen at alarming rates.
General inflation (per cent)
Jan '09: 4.95
Jun '09: -1.01
Apr '10: 9.59
Food (cereals and pulses) (per cent)
Jan '09: 11.25
Dec '09: 20.16
Apr '10: 11.93
Eggs, meat and fish (per cent)
Jan '09: 6.95
May '09: -0.52
Apr '10: 32.24
Fruits and vegetables (per cent)
Jan '09: 17.25
Mar '09: 2.03
Dec '10: 20.61
Apr '10: 6.16
Expert speak
Four economists suggest measures that can keep inflation in check in the short and long term.
Do you think the RBI's prediction of 5.5 per cent inflation by March 2011 will come true?
Jay Shankar: It may reach this level, but the average inflation this year will be quite high.
Ashima Goyal: It depends on whether food inflation abates. This, in turn, will depend on the monsoon.
Shashanka Bhide: Yes, I think the prediction will be correct.
D.K. Joshi: Only if the monsoon is normal and the global commodity prices don't rise.
Does inflation continue to be driven by food supply constraints?
Jay Shankar: No, inflation spilled over from food to manufactured items around January 2010.
Ashima Goyal: No, inflation is becoming broad-based, moving beyond commodity prices.
Shashanka Bhide: It is still driven by supply shortages. The rise in prices of raw materials and wage rates has spread it to other sectors.
D.K. Joshi: It is no longer localised to food and has expanded to raw materials for manufactured items.
Do you think that the government has made adequate efforts to control inflation?
Jay Shankar: No. Food grains should have been released when prices started to go up. The food supply management needs to be more efficient.
Ashima Goyal: No. After the poor monsoon, short-term measures like tariff cuts, free imports and distribution of food stocks were delayed.
Shashanka Bhide: The government should have been more active in the openmarket sales of food grains.
D.K. Joshi: The government did its bit, but slightly late. Also, it should be more active in improving food supply management.
What do you think will be the general inflation level by March 2011?
Jay Shankar: The average WPI will remain above 7 per cent. By March 2011, it should reach 6 per cent.
Ashima Goyal: About 6 per cent.
Shashanka Bhide: I am more optimistic than the RBI.
D.K. Joshi: The WPI should be 6.5 per cent.
