New Delhi/Mumbai: Anew year, a new rate of inflation, and one that is probably lower?
Hold that thought. If food prices made headlines and bothered policymakers last fiscal, this year’s inflation story is likely to see the focus shift to manufactured products.
Economists say the price spurt in this category of industrial goods is not yet over and the challenge in 2007-08 will be to tackle supply problems in these products and check their prices.
According to D.K. Joshi, chief economist at Crisil, a rating agency, inflation would visibly moderate in the next two months, but reaching the central bank’s comfort band of 5.5% would take a while.
This turn of events is somewhat ironic because food price inflation may have actually peaked and is poised to drop with the arrival of the winter wheat crop in the market, even as the effects of the credit squeeze imposed by the Reserve Bank of India (RBI) kick in. Already, several economists working with brokerage houses are predicting that the inflation rate may slide back below 6% soon.
In addition, since inflation in April 2006, the first month of fiscal 2006-07 was high, any deceleration in the first weeks of 2007-08 will, due to a higher base, actually exaggerate a deceleration in the inflation rate.
Inflation is measured on a year-on-year basis, which means that wholesale prices at a given point of time are compared with what they were a year ago. There could be further drops in inflation as the base effect kicks in over the next few months. Citibank economist Rohini Malkani expects inflation to drop as low as 5% by May or June.
However, this depends entirely on how prices of manufactured products behave as the economy is slowly but surely reaching its maximum production capacities.
According to Shashank Bhide, research head, National Council for Applied Economic Research (NCAER), all the core sectors that are booming, such as steel, cement and construction, as well as feeder industries, such as capital goods and automobiles, would sooner or later be short on capacities.
“We have become a high-cost economy and building new capacities in areas where there are capacity constraints would take time as well as money,” he adds.
And since manufactured products have an overwhelming weight (63.75%), any firming up of prices of commodities in this group will have a similar exaggerated impact on the overall price level.
According to Rajeev Malik, economist with JP Morgan Chase Bank, Singapore, manufactured articles’ inflation was 55% of the total wholesale price index (WPI) in March. Higher world prices of metals combined with strong domestic demand last year will directly impact local prices, Malik said. Since both these pressures will continue in 2007-08, manufactured goods’ prices could keep hardening.
“Our forecast envisages a rolling over of headline WPI inflation, though manufactured goods inflation will likely stay higher than the average. This contrasts with the pattern in the last year, when primary article and fuel prices were the key drivers of higher headline inflation,” Malik adds.
The 2006-07 Economic Survey that came out on 27 February first pointed to the rising share of manufactured products in inflation, and tried to make sense of it as against the hype surrounding primary products, which are mainly food. In January 2006, it discovered, manufactured articles contributed 31% of the inflation, while in January 2007, the share was up at 51.5%. In the same period, the share of food price inflation went up from 29.7% to 34.8%.
The survey explained that the main reason for this was the upward pressure in basic metals prices due to lower stocks, high demand from China and stronger global prices. In fact, basic metals’ contribution to inflation went up from 3.6% to 19.7% in January 2007.
One way of reading the underlying trend is that year-on-year in March 2007 (see chart), according to JP Morgan, manufactured products inflation contributed 55% to the overall inflation, compared to only 6.4% in March 2006. This is certainly higher than what it was in January, as the Economic Survey found.
Saumitra Chaudhuri, economic adviser of credit rating agency Icra, says “Manufacturing products’ price rise became evident in August-September 2006. The biggest contributors to this were non-ferrous metals, followed by grain mill products, steel, vegetable oil and cement. Over November-January, the rise went across the board”.
Not coincidentally, the finance ministry had targeted reductions in import duty rates in January-March at this specific segment.
Shubhada Rao, chief economist, Yes Bank Ltd, argues, “Manufactured products inflation has actually shot up to 6.57%, higher than the overall inflation of 6.37% on March 23. I think this would remain at the same levels as the capacity constraints of the manufacturing sector would fail to keep pace with the rising demand.”
Adds Chaudhuri: “The risk to inflation this year comes from two sources. The carryover of higher prices will continue into July-August. Additional price pressures will have the potential to carry inflation into a zone of distinctive discomfort.”
Many analysts in the stock market also hope that a drop in the inflation rate will have an impact on the central bank’s monetary policy, and consequently on interest rates and corporate earnings.
“The higher base of last year has the potential to drop inflation by 100 basis points over the next few weeks. Once inflation is tamed to around 5%, we expect the government to ease its hawkish stance towards several sectors. We attribute the last 200 basis point rise in interest rates largely to the government’s overdrive to curb inflation. With inflation falling to the targeted band of 5 to 5.5% by May 2007, we expect an end of this phase of monetary tightening and fiscal measures,” says brokerage house Motilal Oswal in its India Strategy Report, which was released on 5 April 2007.
Rajat Rajgarhia, the author of the report and head of institutional research at Motilal Oswal Securities Ltd, says he expects lending rates to start declining by the second half of fiscal 2008.
Amitabh Chakraborty, president (equities) at Religare Securities, believes inflation will come under control by the end of April primarily because of two factors—the base effect and effective monetary tightening measures by RBI—which have already helped slow down growth in bank credit and asset prices. A drop in inflation could take some pressure off equity prices, say these analysts.