WPI headline inflation for December was down to 6.2% from 7.5% in November, and core inflation was marginally up at 2.8% from 2.7% in November. CPI inflation for December printed 9.9%, down from 11.2%, and core-CPI (excluding food and fuel) was at 7.9%, marginally down from 8%.
A machine responding to these inflation data, based on the rules laid down in the RBI Governor’s December Policy Reaction Function (PRF), would have raised rates:
*if the expected softening of food inflation does not materialise and translate into a significant reduction in headline inflation, or (read as ‘and’),
* if inflation excluding food and fuel does not fall (presumably both for WPI and CPI), the Reserve Bank will act, including on off-policy dates if warranted.
But the actual decision might be more complicated. The Governor, in his December policy statement, said, “There is, however, reason to wait before determining the course of monetary policy. There are indications that vegetable prices may be turning down sharply, although trading mark-ups could impede the full pass-through into retail inflation. In addition, the disinflationary impact of recent exchange rate stability should play out into prices. Finally, the negative output gap, including the recent observed slowdown in services growth, as well as the lagged effects of effective monetary tightening since July, should help contain inflation”. Much of this still holds. In addition, estimates of conceptual constructs like a neutral rate or potential output gap remains subject to measurement and model errors.
At the heart of the decision, once again, will be the role of interest rates both in reviving investment and in anchoring inflation expectations. Growth concerns remain, particularly given the stress in banking sector assets. Overlaid on these concerns will be the view on inflation trajectory in 2014, given the long lags for monetary transmission.
Earlier, it seemed likely that the repo rate, at 7.75%, would allow RBI to pause for the rest of FY14 and then take a call in April or after, depending on how recovery shaped out in FY15. This likelihood is lower after the inflation prints, but we think the balance of probability still is (significantly) more for a pause than a hike. The reasons are as follows.
First, if three of the four PRF conditions are met, at a time when IIP growth is -2%, and realised GDP growth for FY14 will probably also miss our 4.8% forecast, remaining well below RBI’s forecast of 5%,