In July, India’s inflation reached a 23-month high of 6.07%, when measured using the consumer price index. Inflation based on the wholesale price index for July rose to a high of 3.55%. In both cases, the rise was led primarily by food inflation.

For example, category “food and beverages” accounts for 46% of the consumer price index (the rest comprises housing, transport and communication, fuel, and other items).

CPI-based food inflation climbed to 7.96% in July, versus 3.97% at the same time last year. This increase was driven specifically by inflation in the prices of vegetable (14%), pulses (28%), protein (meat, egg and milk) items and sugar (22%).

According to a press release from the Ministry of Statistics and Program Implementation, the states with a consumer price index inflation rate higher than the national average were Odisha (8.63%), Gujarat (8.18%), Telangana, Andhra Pradesh (7.5% each), Chhattisgarh (7.09%), West Bengal, and Uttar Pradesh (6.3% each).

Link between rains and inflation

One of the reasons for the rise in food inflation during the period was weak monsoon in the preceding years.

India had witnessed below-normal rainfall in 2014 and 15. Food inflation had therefore surged, since deficient rain affects the output of key crops.

However, the link between the monsoon and food inflation is a tenuous one, considering that in 2010 and 2011 – both of which witnessed a good monsoon – food inflation was still high.

The second, more structural reason is government policy. For that, we need to understand the factors at play for the past few years.

Rise in demand

Earlier this year, the International Monetary Fund published a working paper titled, Understanding India’s Food Inflation: The role of demand and supply factors.

The paper analyses food inflation from the demand side (that is, in terms of the growing demand for food as India’s GDP rises) and the supply side (how well equipped India’s food production is to handle this demand).

As the paper notes, during 2005/06-2007/08, while agriculture GDP was growing at 5%, private consumption was growing at almost twice the rate at 9%, causing food inflation to spike.

In subsequent years, this equation reversed. The paper notes that as a result of a good monsoon, agricultural GDP growth recovered in 2010-'11 to 8.5% and in 2011-'12 to 5%. "Simultaneously, with a concurrent moderation in private consumption growth due to the economic slowdown, relative food prices remained broadly stable" during this period, the paper said.

Supply-side factors

However, on the supply side, things get complicated. As the paper notes, during the last five years, buffer stocks held by the Food Corporation of India were more than double the norm because of several factors, such as lack of a proactive liquidation policy, export bans etc.

Carrying excess stocks can be expensive – the economic cost to the Food Corporation of India to acquire, store and distribute food grains is 40-50% more than procurement prices.

An increase in minimum support prices was key to this increase in stock and the rise in food inflation. As the paper notes, “The strong building up of buffer stocks was undoubtedly aided by large rises in minimum support prices, which during this period averaged about 13% per year, even as headline CPI inflation averaged about 9% and WPI inflation slightly above 7%.”

Government policy, thus, plays an important role in food prices and, therefore, the rate of food inflation.

Silver lining

On the bright side, we can expect food inflation to come off current highs in the next few months. The monsoon this year has been above average in most of India, which has already started having an effect on food prices and the impact will be more visible in coming months. For instance, in July, food inflation rose by 50 basis points, compared to a 100-basis-point rise in April and May over the months before that. As the monsoon reaps its full results, food inflation should climb down. In Maharashtra, pulse prices have reportedly already started to dip.

Also keep in mind that the government has set an official target of 4% for overall inflation, with a variance of +/-2% (compare this to the 6% consumer price index inflation reported in July 2016). Prime Minister Narendra Modi also spoke about it in his Independence Day speech. Controlling food inflation will be central to this.

What to watch out for

While the outlook is positive, two things could play spoiler. The first is crude prices. These have remained low over the past few years and till the time they stay less than $60 per barrel, they should not have a significant effect on inflation. Any rise above this level, however, will hit inflation hard, since transportation costs are a major component of food prices.

Also, implementation of the Seventh Pay Commission will see a increase in salaries for Government employees. While this should drive consumption growth, it could also have an impact on inflation. Both factors are yet to play out and should be watched out for.

Anupam Gupta is a Chartered Accountant and has worked in equity research since 1999, first as an analyst and now as a consultant. His Twitter handle is @b50.