Column: Time to hold nerve, and rates

Written by Siddhartha Sanyal | Siddhartha Sanyal | Updated: Dec 18 2013, 10:43am hrs
Inflation headlines, both wholesale and retail, continued to spring upside surprises in the recent months building up expectations of further monetary tightening by RBIrepo rate hikes, in particular.

However, while the inflation prints indeed remain way higher than the comfort zone, it is important to see the state of the economy in a more holistic wayincluding growth momentum, capacity utilisation in the economy, pricing power in industry, and the contribution of demand side pressures in todays inflation. Most of these factors would not suggest further rate hikes at the current state of the economy, in my view.

Narrow-based spike in inflation dissipating

The jump in inflation prints in recent months had been driven almost entirely by vegetable priceswhich have recorded an unusual spike of nearly 80% yoy during H2FY13 so far (the highest since 1998), overshadowing disinflationary trends in several other commodities. Of the almost 300 bps uptick in WPI inflation since May, vegetables have contributed nearly 200 bps despite the tiny weight (1.7%) of this category in the WPI basket. WPI ex-vegetables (98.3% of index) was about 5.5% yoy in November, well below the headline rate of 7.5%. The December WPI can be close to 6.5%

CPI, ex-vegetables, is falling

Vegetable prices are typically volatile, and such sharp price spikes usually do not last beyond 3-6 months. Anecdotal evidence suggests that a normalisation in vegetable prices has already startedfor example, wholesale onion prices have fallen about 50% since mid-Novemberbut this is yet to be reflected in official statistics. The softening in vegetable pricesonce captured by the official statisticscan potentially lead to a significant drop in WPI headlines. Under our conservative assumption of a 30% month-on-month drop in vegetable prices, the headline WPI reading will likely drop by about 100 bps to reach close to 6.5% in December.

Core inflation (2.7% yoy as per the latest print) still remains considerably low, as expected, reflecting weak economic momentum. Demand-side pressures on industrial inflation remain absent, as suggested by weak industrial activity. Indeed, capacity utilisation by Indian industry is currently at the lowest since early-2009, and continues heading further south. This, along with several other anecdotal evidences, suggests weak pricing power and absence of demand overheating in the domestic economy. It is important to recognise the limitation of monetary policy in containing inflation and the potential adverse effects of further rate hikes against the current backdrop. For example, NPAs in the banking sector is currently the highest in the last 7-8 years, despite bouts of restructuring of corporate loans, and the adverse effects of further interest rate hikes at this stage would likely be more than proportionate.

Further rate hikes in reaction to high non-core inflation would mean unduly penalising the industrial sector further where pricing power and capacity utilisation are at multi-year lows at the moment.

Core inflation reflects idle capacity, weak pricing power

The sharp near-20% depreciation of the rupee over June-August had been another factor in higher prices, given upside pressure from imported inflation. Typically, the effects of a weaker currency are captured partly in (a) a lagged effect on core inflation (which encompasses metals, chemicals, etc) and partly in (b) administered inflation, particularly domestic energy prices. Given that the rupee has stabilised since September, we expect the incremental impact of a weaker currency on core inflation in coming months to remain tempered. Also, administered hikes in domestic energy prices could also be somewhat tempered as the elections draw closer.

Government too needs to play its role

Admittedly, the recent unexpected spike in inflation headlines has enhanced the pressure on the central bank. But, more importantly, weakness in growth remains broad-based, while the recent spike in inflation does not reflect any meaningful contribution from demand overheating. Inflation expectations, which have been affected of late, remain a key consideration for policymakers.

While we agree completely on the importance of anchoring inflation expectations, we think it is difficult for RBI to achieve this in the near term when higher inflation is being driven by food prices and not by demand overheating. The role of the government and administrative policies (e.g., ensuring smooth logistics, curbing hoarding, breaking cartels of traders and middlemen, ensuring strategic imports) will have far greater influence in the current environment to control prices and to anchor inflation expectations.

The author is chief India economist, Barclays