Headline inflation may have come off to 7.5% year-on-year for November and the base effect may push inflation down to somewhere between 6-6.5% by March end but problems relating to high prices will not end there. The main reason for this is the rising price of crude oil, which is nudging $90 a barrel and also the jump in prices of other commodities. Also, while food inflation may have come off to single digits after 17 months, prices of food are likely to remain high what with prices being influenced by structural factors, and the unseasonal rains having impacted sowing of the winter crop. With fuel prices already being increased, if the government raises diesel prices by about a rupee, as is being suggested, it can only make things worse, eating into disposable incomes. Already, producers of cars and two-wheelers have increased prices. As such, while the macroeconomic data so far has been good in terms of both the IIP growth of 10.8% for October and the GDP growth of 8.9% for the September 2010 quarter, high inflation could queer the pitch going ahead.
Of course, the Reserve Bank of India (RBI) is unlikely to increase rates on December 16. That?s because banks have already raised lending and deposit rates; in other words the monetary transmission that the central bank was looking more is already happening and short-term rates are at one year highs. Equally important, the system is woefully short of liquidity thanks partly due to the government?s balances with the RBI at close to Rs 1 lakh crore and currency with the public also at similar levels. It?s hard to justify a rate hike under the circumstances. However, by late January or early February next year, the central bank could once again start tightening rates if inflation doesn?t come off as expected and the consensus is that there could be two to three hikes spread over 2011. That cannot be good news for either companies or consumers because at some point the higher cost of money will begin to pinch. And that will hurt demand, especially if rural incomes aren?t robust enough. Thus far, India?s earnings growth has been driven by consumer spending and the promise, that profits would continue to grow at around 15-20%, has attracted record foreign inflows that have driven up the markets. However, an abundance of liquidity globally is pushing up prices of commodities, upsetting the macroeconomic environment?a higher import bill means a higher current account deficit. The recent scams may not have rattled foreign investors yet, but would begin to, unless they come to an end. But it?s earnings growth that?s key for investors and any signs of a slowdown can make earnings appear inflated and the markets expensive. For the past month or so foreign investors have been adding to their positions in Korea, Taiwan and other Asian markets and taking risk off the table in India, primarily because the Indian market was expensive. Even after the correction post the highs of early November, India trades at a significant premium to peers like Korea and Taiwan. If earnings don?t keep up with expectations, this premium will soon diminish.
