Tightrope walk by RBI: 5 points

Updated: Aug 13 2014, 23:16pm hrs
Tightrope walk for RBI as inflationary pressures remain. The effect of a weak monsoon was visible in higher CPI inflation led by 17% rise in vegetable prices from last month. This was coupled with June IIP growth at a lower-than-expected 3.4% led by 10% contraction in consumer goods production. With the growth-inflation mix continuing to be adverse, we expect some relief from the pick-up in monsoons helping smoothen out price pressures over the next few months. With upside risks remaining to the 8% target for CPI inflation by January 2015, we expect the RBI to remain guarded and on an extended pause.

Retail inflation sees the effects of higher vegetable prices; core inflation stable

In line with our expectation of 7.8% (consensus at 7.4%), July CPI inflation moved up to 7.96%. This was due to 17% increase in vegetable prices from June. Most of the other factors remained stable indicated by the core inflation (non-food inflation) remaining unchanged at 7.4% from June. However, the risks of pass-through of food inflation to generalized inflation will keep the RBI guarded against any secondary impact through the expectations channel. We expect vegetable prices to smoothen as the monsoon normalizes, though there could still be some risks to retail inflation staying within the RBIs target of 8% by January 2015.

Weak consumer goods production leads to lower-than-expected IIP growth

We were surprised by the higher-than-normal 23.4% contraction in consumer durables. In absence of any further details, we conjecture that the yoy contraction was led by radio, TV and communication, etc. ((-)62.9%), office, accounting & computing machinery ((-60.5%), furniture manufacturing ((-)13.4%) and wearing apparel ((-)6.6%). This was despite one of the major components motor vehicles growing 7.3%. Consumer non-durables grew 0.1% and capital goods production grew 23%.

Risks of monsoon-led shocks to the economy abating

The upside risk to inflation seen till early July due to a weak monsoon has abated with the revival in rainfall across the country. According to our estimates, July rainfall has ~50% correlation with kharif production. The seasonal rainfall deficit improved to 18% below normal till August 6, which is an improvement from 42.2% below normal rainfall till July 6. Kharif acreage till August 8 is 9% lower than last year, an improvement from 44% till mid-July. The reservoir levels have also sustained at ~10-15% above normal levels and hence, reducing the risks of any slippage in rainfall. However, risks of late withdrawal of monsoon or unseasonal rainfall that can damage standing crops before harvest in 3QFY15 still remain (typically onion and potato crops).

RBI to remain on wait-and-watch mode

The RBIs reaction function will hinge on retail inflation transitioning to 6% by January 2016, which would require a structural shift in inflation dynamics. The key risks for the RBI to lower policy rates would be: (1) meaningful and sustained reduction in food prices, (2) qualitative and quantitative correction of fiscal imbalances, (3) supply-side correction to accommodate higher aggregate demand without inflationary pressures and (4) global events like geopolitical risks, commodity prices and other global central banks action. In the near term, upside risks to the 8% mark by January 2015 (as is also indicated by our CPI model) will keep the RBI guarded and hence we maintain our call for an extended pause till end-CY2014.

By Kotak Institutional Equities