CPI inflation peaked at 7.3% in Dec; we expect RBI MPC to go for a dovish pause on February 6, cut rates by 25bp in April
We grow more confident of our call that CPI inflation has peaked at December’s 7.35%. We track January at 6.7%, with onion prices coming off to an average of Rs 66 per kg in January so far from Rs 95 per kg in December. January CPI inflation falls further to 6.1%, on a point-to-point basis, as onion prices dropped to Rs 52 per kg as of writing. If onion prices fall to Rs 20 per kg, CPI inflation would drop to 4.3% in March. That’s why we do not really lose sleep over the CPI inflation spike driven by the temporary jump in onion prices as well as base effects that should reverse from February. After all, all fundamental drivers of inflation remain weak: high 250-plus bp output gap, tight liquidity, a good summer harvest as well as low ‘imported’ inflation due to relative rupee stability and subdued commodity prices. Not surprisingly, core CPI inflation has fallen to 3.07% from 3.68% in September in contrast to headline inflation jumping 335bp over the same period.
We remain far more concerned about rising real lending rates, on falling core WPI inflation, pushing back recovery than the jump in headline CPI inflation. Latest WPI data show core WPI inflation has slipped to 1% in December from 2.3% in March. While nominal MCLR has fallen 45bp since March, on RBI easing, real MCLR (MCLR-core WPI inflation) has shot up 83bp on falling core WPI inflation. Against this backdrop, we expect RBI MPC to go for a second dovish pause on February 6 and cut rates by 25bp in April.
Inflation has already peaked at 7.35% in December (see graphics). Our daily price tracker shows that both wholesale and retail prices of onions have started to come off. Onion prices are down 30% MTD. In fact, a point estimate places January CPI inflation at 6.1% with onion prices falling to Rs 52 per kg as of writing. So, when will inflation revert to RBI’s 2-6% mandate? By March, to 4.3%, assuming onion prices fall further to the regular Rs 20 per kg by then. Base effects will fade by February. Inflation may stabilise around 4% again by October, assuming normal rains—the Australian weather bureau sees rainfall conditions as neutral so far.
Fundamental drivers of inflation weak
We do not set much in store by the jump in CPI inflation as this is primarily driven by a temporary onion price spike and the statistical base effect of the dip in CPI inflation last year.
Substantial output gap restrains corporate pricing power. Our BofA India Activity Indicator is signalling the worst is over, albeit at a deeper and longer bottom.
Liquidity remains tight (excess M3 demand is 0.8%).
Agflation should be in check with winter rabi sowing improving to 9.5% year-on-year.
‘Imported’ inflation is muted, with RBI FX intervention limiting depreciation (1.1% FYTD) as well as soft weak world growth holding global commodity prices. We also do not see our expected 0.5% of GDP fiscal slippage pushing up inflation given the large output gap. We expect Budget 2020 target fiscal deficit at 3.8% of GDP (vs 3.3% budgeted) in FY20 and 3.5% in FY21. It is well below the long run 4.5% average.
(Excerpted from BofA Global Research ‘India Economic Watch: CPI inflation has peaked’, dated January 28, 2020.)