Lower inflation to open door for policy easing

March 14, 2020 7:10 AM

Expect a 50bps cumulative repo rate cut in 2Q2020, liquidity easing, and targeted fiscal support.

Protein food items that rose sharply in past months have been relatively subdued.

By Sonal Varma and Aurodeep Nandi

CPI inflation eased to 6.58% year-on-year (y-o-y) in February vs 7.6% in January, lower than expected (Consensus: 6.7%, Nomura: 6.5%). Food price inflation moderated to 10.8% y-o-y vs 13.6% in January, reflecting the second month of sharp month-on-month (m-o-m) correction in vegetable prices (-13.4% m-o-m) after months of unseasonally high upticks (average in Q4 = 7.8% m-o-m).

The ex-vegetable food basket, too, showed signs of easing price pressures. Protein food items that rose sharply in past months have been relatively subdued. Meat and fish prices fell to 0.06% m-o-m vs ~1.5% in January, as have prices of eggs (-2% vs 2.5%), milk (0.5% vs 1.2%), and pulses (0.5% vs 1.5%). Oils & fats, and spices have also reduced from past month’s levels, although they also showed strong pick-up in prices over the month.

Food (ex-vegetable) inflation has, nevertheless, remained constant since January at 7.2% y-o-y. Its cumulative increase of 1.25% m-o-m in January-February remains higher than the average rise during 2014-16 (0.75%). Fuel and light inflation spiked to 6.4% y-o-y in February vs 3.7% in January, reflecting a sharp upward revision in LPG cylinder prices (8.4% m-o-m).

Core inflation (CPI ex-food and beverages, fuel) moderated to 3.9% y-o-y in February vs 4.3% in January (see graphic). Most core sub-components reflected lower m-o-m increases compared to January, with transport and communication contracting—in part reflecting the moderation in oil prices. Seasonally adjusted (sa), “super-core” basket (CPI ex-food & beverages, fuel, petrol, diesel and housing rent) fell to 0.19% m-o-m (sa) vs 0.71% in January (Fig 4). Our measure of trimmed mean CPI fell to 4.2% y-o-y vs 4.4% in January.

Industrial production (IP) growth picked up to 2% y-o-y in January vs an upward revised 0.1% in December (-0.3% previously), better than expected (Consensus and Nomura: 0.5%). On a seasonally adjusted basis, IP rose by 1.3% m-o-m vs -1.8% in December. The relative performance of the sub-components remained unchanged and weak. Intermediate goods output growth continued to lead the pack, up by 15.8% y-o-y vs 12.4% in December.

By contrast, output growth contracted in all other segments: capital goods (-4.3% vs -18.2% in December), infrastructure goods (-2.2% vs -2.1%), consumer durables (-4% vs -5.4%) and consumer non-durables (-0.3% vs -3.9%). We believe COVID-19-led disruptions to supply chains of key industries will start to reflect in the IP prints from February.

Our comment: Does inflation even matter?
A number of reasons are behind our conviction that inflation appears poised to fall sharply. First, the ensuing correction in vegetable prices looks set to continue in March and possibly April, albeit to a lesser extent. Data on the first 11 days of March show our index for key vegetable prices contracted by 9.9% m-o-m vs -25.4% in February.

Second, the plunge in crude oil prices from an average of ~$55/bbl in February to ~$43/bbl in March, thus far should not only result in lower retail prices for fuel products but also lower cost of production for various industries. Even after accounting for a weaker rupee, lower oil prices should ease headline inflation by ~20bps.

Third, the hike in LPG cylinder gas prices has already been partially reversed in March. Fourth, there are signs that food price pressures may be tapering off. Farm gate price of a number of pulses are below the government’s minimum support prices. Along with a good rabi crop and a slump in poultry markets owing to the COVID-19 scare, this should ease food inflation.

Fifth—we expect growth to slow sharply in the coming quarters, which is likely to cap core inflationary pressures. Key upside risks to inflation include: higher gold prices (part of personal care), weak rupee and COVID-19 disruption to supply chains in sectors like pharmaceuticals, autos and electronics. The latter can potentially add ~20-30bps to headline inflation if passed through.

Nevertheless, we expect disinflationary pressures from lower commodity prices and weak demand to dominate, and inflation trajectory to trend downwards. We expect CPI inflation to reduce from ~6.6% y-o-y in Q1 to 4.5-4.4% in Q2-Q3 and 2.4% by Q4. But, relying on inflation for monetary policy will likely be backward looking. Thus far, higher inflation has limited RBI’s ability to ease policy rates, despite downside risks to growth. RBI has worked around this through a combination of dovish guidance and unconventional liquidity and forbearance measures.

However, two key developments suggest a growing urgency to deliver further easing. First, the COVID-19 outbreak is translating into a significant global growth shock that could potentially extend until Q2. We expect globally coordinated policy response to continue with the US Fed and the Bank of England to hit their effective lower bounds by Q2, easing by 100bps and 15bps respectively. Second, India faces a domestic challenge of faltering financial stability, with the fall of one of the largest private sector banks.

While the government-RBI sponsored rescue plan is still in the works, there are concerns that this may have other spillover effects due to elevated risk aversion among depositors and erosion of confidence in smaller private sector banks, shadow banks, and corporates with weak balance sheets.

The combination of belligerent global shocks meeting domestic shocks heightens the urgency of RBI to respond with an ‘easing package’. In our view, on the conventional side, this involves a cumulative 50bps rate cut by Q2, which could be delivered before the April 3 meeting. On the unconventional side, we expect further commitment by RBI to keep liquidity flush by announcing the next tranche of long-term repo operations (LTRO), possibly redesigned to target bank lending, and/or a sizeable open market operations.

Tweaks in macro-prudential policies like risk weights of banks towards various sectors, could also be announced. In addition, the government could announce targeted fiscal policy measures for the worst affected sectors—travel, hotels, SMEs.

Authors are research analysts with Nomura Holdings. Views are personal.

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