Retail inflation: finding the floor. February inflation continued to signal the ongoing disinflationary process. However, we believe that price corrections in food and petroleum products will taper off from here. The downward trajectory is likely to continue and reach a bottom in July-August. However, much of this would likely be due to positive base effects. We expect inflation in CY2015 to reach ~5.5% by January 2016.
We factor in 25 bps of further rate cuts with an outside chance of 50 bps of cuts.
Inflation may not see much downside from current levels; watch for favorable base effects
We do not expect any significant downside from the current levels of inflation. The disinflationary process through lower vegetable prices and commodity prices is likely to have run its course. We believe that prices have stabilized and key elements in food prices such as vegetables, pulses, etc. will see some seasonal upside from here. Crude price-led correction in the transport and communication segment will also start to reverse as the OMCs adjust to relatively higher crude prices as also the likely depreciation pressures on the INR. However, in the new series, as compared to the old series, there is a slightly higher base effect that can push inflation lower around July.
February inflation maintains disinflationary mode
February inflation at 5.37% (5.19% in January) was led by marginally higher food and beverages inflation at 6.8% (6.3% in January) and fuel and light inflation at 4.7% (3.8% last month). The continuation of the disinflationary process was underpinned by core inflation, which at 4.1% (earlier at 4.2%) was indicative of the muted demand scenario. Housing inflation was at ~5% with ‘miscellaneous’ (mostly services sector) component of inflation falling further to 2.9% from 3.1% in January. Significant drops in core inflation could be restricted due to higher service tax rate impacting price levels. The uptick in yoy food inflation was led by higher prices for protein items, vegetables (base effect) and pulses.
IIP growth surprises on account of capital goods
The significance of IIP has considerably reduced with introduction of the new GDP series. However, in the absence of an updated series, we continue to draw signals for the industrial sector growth from the IIP series. The January print at 2.6% was higher than expected on the back of sharp improvement in capital goods production, contrary to the usual trend. This is the first time that capital goods production in January has increased on a mom basis. Manufacturing production growth at 3.3% was led by production growth in larger segments such as basic metals (13.7%), electrical machinery (28.1%), furniture (23.5%), rubber and plastics (15.3%), etc.
We factor in 25 bps of incremental rate cut in CY2015; outside chance of 50 bps
Our revised trajectory (realigning to new series) indicates that inflation can reach a low of ~4.0% in August but will recover to ~5.5% by January 2016. However, as we note earlier, much of the drop in inflation from current levels will be due to base effects rather than continued price corrections. If the RBI chooses to gloss over these base effects, the window to reduce policy rates is much restricted given that the Federal Reserve may start to hike interest rate sometime during June-September. The RBI in its last policy communique had indicated that further policy actions would depend on some qualitative indicators, which, in our view, are likely to be achieved only in the medium term (availability of power, land, minerals, progress on fiscal consolidation, etc.). Factoring in these issues, we maintain our call for 25 bps of incremental rate cut (likely in June rather than in April). Incremental rate cut of 50 bps from the current level remains an outside chance, in our view.