Clearly, the November CPI has been significantly higher than market expectations and RBIs projected trajectory as given in the October monetary policy statement. However, the surprise came from a rather unusual source. The CPI index went up 1.4% between October and November (month-on-month change) which was primarily driven by a 9.3% month-on-month increase in vegetable prices, and even in WPI, vegetable price inflation was at an all-time high of 95%. In fact, the core CPI (ex food and fuel) has actually declined marginally in November to 8% from 8.1% in the earlier month. It is true that vegetable prices were rising consistently in the last few months and the vegetable price increase in the CPI index (46% year-on-year in October) was lagging the increase in WPI index (78% year-on-year in October).
So, this could simply be a catch-up to wholesale prices but this runs contrary to the argument that the fresh supply arriving in October and November should have addressed the temporary shortage in the earlier months.
To better understand this puzzling issue of rising vegetable prices in the CPI, we looked into state-level CPI data and found an interesting peculiarity. The states that fell in the path of the cyclone Phailin had much higher month-on-month inflation for November. Although Phailin had hit the shores mid-October, it is possible that the damage it caused to crops (particularly potatoes and rice) and to transport infrastructure has led prices to rise with a small lag in November. Orissa (3.8%), West Bengal (2.3%), Jharkhand (2.4%), Bihar (2.8%) and Andhra Pradesh (1.2%)states which were impacted by the cyclone Phailinreported much higher month-on-month increase in CPI compared to other states like Maharashtra (0.5%), Madhya Pradesh (0.5%), Gujarat (0.5%), Tamil Nadu (0.6%), etc, which were unharmed by Phailin. Also, the northeastern states witnessed high inflation because they are often dependent on supplies from the Phailin-affected states. It gives us hope that the vegetable price increase in November was most likely localised, caused by a natural event shock, and that the trend will reverse in the coming months.
In our view, about 80 bps of additional impact on CPI came from the cyclone Phailin. Even after adjusting for that, CPI still remains uncomfortably high, in double digits. Although the core CPI is falling marginally, the pace of moderation is too slow. Also, the RBI Governor mentioned in his post-October policy comments that we believe that at this point where we have left the interest rates is consistent with our projections going forward. Since the inflation trajectory has been much higher than projections, a 25 bps hike in repo rate is needed to confirm RBIs anti-inflationary credibility and ensure that this bout of food inflation does not get generalised. Household inflationary expectations have shot up as per the RBI's September survey and there is a risk of that spilling over into higher wages. Although the RBI Governor has acknowledged growth concerns, we think that inflation is likely to remain the focal point for monetary policy.
Another aspect of the December monetary policy would be RBIs stance on further normalisation of the exceptional liquidity tightening measures undertaken in July. The central bank had earlier hinted that this process is going to be a function of how the external imbalances shape up and how the currency responds to that. The good news is that the current account deficit has fallen to just 1.2% of GDP in the September quarter. RBI has been able to garner $34 billion through its concessional swap schemes and there has been no major disruption in the currency market even after the return of oil companies. With the currency stable even against the backdrop of mild QE tapering fears, RBI should be more comfortable about making the repo rate the operational overnight rate now. In fact, from end-November, as RBI has infused rupee liquidity in the system by buying dollars under the concessional swap schemes, the overnight rates have dropped below the repo rate.
Also, since RBI is adding adequate liquidity through the term repos, any further step to ease the cap on borrowing under the overnight repo window is going to be rather symbolic. If improving the depth of the term repo market dominates RBI's agenda, then there may not be any meaningful easing of the cap in borrowing in the overnight repo window.
Otherwise, normalising the monetary policy operating procedure along with a hawkish bias through higher policy rates seems to be the prudent course in the December monetary policy meeting.
The author is managing director & regional head of research, South Asia Global Research, Standard Chartered Bank