Column: Time to hold nerve, and rates

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SummaryFurther rate hikes in reaction to high non-core inflation would mean unduly penalising the industrial sector

Inflation headlines, both wholesale and retail, continued to spring upside surprises in the recent months building up expectations of further monetary tightening by RBI—repo rate hikes, in particular.

However, while the inflation prints indeed remain way higher than the comfort zone, it is important to see the state of the economy in a more holistic way—including growth momentum, capacity utilisation in the economy, pricing power in industry, and the contribution of demand side pressures in today’s inflation. Most of these factors would not suggest further rate hikes at the current state of the economy, in my view.

Narrow-based spike in inflation dissipating

The jump in inflation prints in recent months had been driven almost entirely by vegetable prices—which have recorded an unusual spike of nearly 80% yoy during H2FY13 so far (the highest since 1998), overshadowing disinflationary trends in several other commodities. Of the almost 300 bps uptick in WPI inflation since May, vegetables have contributed nearly 200 bps despite the tiny weight (1.7%) of this category in the WPI basket. WPI ex-vegetables (98.3% of index) was about 5.5% yoy in November, well below the headline rate of 7.5%. The December WPI can be close to 6.5%

CPI, ex-vegetables, is falling

Vegetable prices are typically volatile, and such sharp price spikes usually do not last beyond 3-6 months. Anecdotal evidence suggests that a normalisation in vegetable prices has already started—for example, wholesale onion prices have fallen about 50% since mid-November—but this is yet to be reflected in official statistics. The softening in vegetable prices—once captured by the official statistics—can potentially lead to a significant drop in WPI headlines. Under our conservative assumption of a 30% month-on-month drop in vegetable prices, the headline WPI reading will likely drop by about 100 bps to reach close to 6.5% in December.

Core inflation (2.7% yoy as per the latest print) still remains considerably low, as expected, reflecting weak economic momentum. Demand-side pressures on industrial inflation remain absent, as suggested by weak industrial activity. Indeed, capacity utilisation by Indian industry is currently at the lowest since early-2009, and continues heading further south. This, along with several other anecdotal evidences, suggests weak pricing power and absence of demand overheating in the domestic economy. It is important to recognise the limitation of monetary policy in containing inflation and the potential adverse effects of further rate hikes against the current backdrop. For example, NPAs in the banking

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