Return of the prodigal

Written by Soumya Kanti Ghosh | Updated: Aug 16 2013, 07:31am hrs
The July inflation numbers at 5.8% have rattled the markets. Many fear that the battle for inflation is now far from over. With the rupee still struggling to find its feet, its impact on inflation may get pronounced in the coming days. Interestingly, I had not shared this view till date, but may be now constrained to do so. This is because the inflation numbers in July have a structural break that is distinct and revealing.

Consider the following statistics. Even as the rupee depreciated from 44 to a dollar in July 2011 to 57 by the end of May 2013, imported inflation actually declined from 10% to 2.3% in the concomitant period. This was a reflection of complete lack of pricing power on the part of corporates and soft global commodity prices with the economy demand constrained. However, with the rupee depreciating by close to 6% between May and July, imported inflation actually climbed by 1.7% and it rubbed on WPI by 1.2% increase. More precisely, in the last one month, with imported inflation climbing by 1%, WPI has also climbed up by nearly 1% (4.9% in June 2013 to 5.8% in July 2013). This means, the increase in inflation in the current month has to completely (if not fully) do with rupee depreciation that has impacted fuel non-administered component of fuel inflation (contribution of fuel part jumped to 32% in July 2013 from 23% in March 2013).

Next, the question of food inflation. If we dig dipper, we get some revealing statistics. As expected, the spurt is being driven by increase in vegetable prices. For example, vegetables now contribute close to 20% increase in overall inflation. Some of the items that are causing this spurt are obviously onion but not so obvious items like brinjal and even ginger! Thankfully, it seems that protein and milk inflation is now not a problem, as the contribution have plateaued in recent months. Ditto with fruit inflation, that is now showing a de-growth. On the other hand, cereal inflation is showing signs of minor uptick. Thus, in a major departure, conventional items like vegetables and cereals are now coming back to haunt us, instead of protein and milk!

The other disturbing sign is that core CPI numbers have significantly edged upwards in the July print. For example, core rural CPI has jumped to 6.9% (vis--vis 6.6% a month ago), combined core CPI has jumped to 7.6% (6.8% in the preceding month). This indicates the current spurt in food inflation, coupled with rupee volatility, is actually playing havoc with a consistent build-up in inflationary expectations over the medium term.

Even as we grapple with rising inflation, the moot question is how quickly can we salvage the decline in rupee value Here there cannot be any straight answer. Consider graph 2, which plots the difference between 1-year rupee yield and 1-year implied yield as calculated from the NDF market in Singapore. Given that this gap is a positive differential, we would expect the rupee to appreciate, as per textbook logic. However, contrary to such, the rupee is still depreciating and it actually goes against the conventional wisdom. The only way we can explain this reverse correlation is that the current bout of rupee depreciation may be because of weakening macro fundamentals.

The spurt in inflation is a cause for concern and we hope that this trend is reversed soon. The apex bank has widened the LAF corridor in an effort to rein in the rupee fall, but the impact is yet to be seen. There has been a hardening of yields across the entire maturity spectrum, with more so at the short end. But the bad thing is that the benchmark 10-year bond has also moved up by 84 bps since July 15, 2013. The relentless fight against the rupee is taking its toll. Interestingly, trends suggest that the average duration of volatility in forex market is roughly 3-4 months (purely based on past trends). If that is correct, there is perhaps light at the end of the tunnel soon.

The author is chief economic advisor, State Bank of India. Views are personal