In March, we had forecast that the appropriate indicator of inflation, the consumer price index, had peaked in late 2009 and would decline to the ?5% range? in the next six months. We stand by our forecast?especially on the decline though we might miss the level by a month or so. Based on the analysis contained in this report, we make a new forecast?RBI should be done with raising rates.

RBI still believes that demand-pull inflation is an important part of the story. The trends in three indicators of demand are examined below.

Investment: This GDP-based series is volatile but the y-o-y rate has declined to less than a zero per cent rate in March 2010-March 2011! There are only two other instances of negative growth in this series since the availability of quarterly records in the second quarter of 1996?minus 5% in the first quarter of 2001, and minus 1.7% in the third quarter of 2009.

Consumption: Growth in private final consumption expenditures?seasonally adjusted annual rate?has declined to a less than 5% rate, the lowest since 2005 if one excludes the 2008 recession quarters in 2008. This decline is observed in the high growth quarter of January-March 2011. For the last three quarters (June 2010-March 2011), consumption growth has averaged less than 5%. Since India?s growth acceleration began in 2003-04, and excluding 2008, both the mean and the median for consumption growth are close to 7%. To reiterate, the last quarter for which RBI had GDP data (January-March 2011), the evidence is overwhelming that consumption growth was not strong?indeed, was quite weak.

Industrial production: If RBI is not convinced with the above data about growth being weak, it will likely not be moved by the data on industrial production (new series). The IIP y-o-y rate registered a big decline from its peak rate of 13%, a year or so ago. May 2011 growth rate of 5.6% (y-o-y) is the smallest gain in the last 7 years?again, after excluding the recession year of 2008. The saar 3-month growth is now negative (minus 5%) and, barring the 2008-09 recession years, is the lowest since 1993-94. The 6-month saar rate is somewhat better at 3.4% but only because of the exceptionally strong first quarter of calendar year 2011. But that quarter belonged to the previous fiscal year.

The real story of inflation

Simply put, the occurrence of higher than expected inflation in India is not because of the fiscal deficit, money supply growth, commodity prices, or international inflation. But it is because of the populist, Machiavellian re-election vote-bank policies of the Congress, a party in power for the last 7 years.

Procurement prices for agriculture set in motion a chain reaction, which affects all other prices in the economy. The price of food goes up, which sets an increase in wages, which results in costs going up, which means output prices go up, which means an increase in CPI (and WPI).

The effect of procurement prices on inflation is tested in a two-stage process. The increase in MSP in any given year is a function of the inflation (CPI) in the previous year. In addition, there is an election year variable, which is ?on? in the year of the election and the year prior to the election. This gives time to the government to set in motion its re-election policy! Two elections are ?dummied out? in the statistical analysis?the 1984 election, which was the result of the assassination of Indira Gandhi and the 2004 election, which is a real low outlier in terms of the increase in agricultural prices.

The model is run for the period 1978 to 2011 and the results are as follows (all coefficients statistically significant).

MSP Inflation = 2.3 + 0.53*CPIt-1 + 2.7* (Election years).

This equation yields the average inflation in procurement prices with zero lagged CPI inflation to be around 2.3%; each 1% rise in the previous year?s CPI inflation sets in motion an extra increase of 0.53% in the MSP. And in each election episode, the government sets the MSP to be an average extra 2.7% higher.

How well does procurement price inflation explain consumer price inflation? Very well. For the period 1978 to 2006 (i.e. before the resurgence of CPI inflation in India), and with year dummies for outlier years 1983, 1991 and 1998, the variance explained is 56%.

CPI inflation = 5.1 + .30* (% change in the average procurement price).

This suggests that, for every 10% increase in the index, there is a 3% increase in CPI inflation. For zero increase in procurement prices in any given year, CPI inflation would be, ceteris paribus, 5.1%. During the out of sample period 2007 to now mid-2011, procurement prices have risen by 75%. (For the re-election years 2008 and 2009, procurement prices rose by 37%). On the basis of procurement prices alone, annual CPI inflation should have been higher by about 4.5 percentage points above the ?base? of 5.1% for each year during 2007 to 2011?i.e. it should have averaged 9.6% annually. Actual CPI inflation for the same period was 9.5%! And this level of accuracy is without any RBI or money supply growth or fiscal deficits or overheating in the model?only procurement prices!

It is revealing that in the major re-election year of 2004 for Vajpayee?s government, international food prices went up by 15.2%, the predicted MSP increase was 6%, yet the actual increase was only 2.4%, the third lowest increase on record. The two lower MSP increases were in 1975 (0.9%) and 2002 (1.3%).

Some firm conclusions …

First, aggregate demand is not even close to being as strong as RBI would have us believe. In fact, domestic demand growth (consumption, investment, IIP or PMI), whatever your fancy, has slowed down drastically over the last 5-6 quarters.

Second, there is a strong relationship between the politically determined minimum support prices (MSP) in agriculture and the overall level of inflation. For every 10% increase in procurement prices, CPI inflation rises by 3%. With the next general elections not till 2014, and growth slowing down, there is little likelihood of another round of unjustified increases in the MSP. As a result, CPI inflation is set to decline to less than 6% in the next few months, and RBI?s repo rate should follow with a lag.

This is an abridged version of a recent report by Oxus Investments on Indian Inflation entitled: ?Indian Inflation: Populism, Politics and Procurement Prices?

The author is chairman of Oxus Investments, an emerging market advisory and fund management firm