Rate hike likely as prices rise

Rate hike likely as prices rise

New Delhi: The economy is perilously close to returning to double-digit inflation. While provisional headline inflation accelerated to 9.06% in May, revised data for March showed it at 9.68%. Provisionally it was reported at 9.04% in March.

Not only is it politically a setback for the scam-scarred United Progressive Alliance, it increases the prospects of a fresh round of rate hikes by the Reserve Bank of India (RBI) at its review of monetary policy on Thursday and threatens to derail the economy’s growth trajectory—the latest spurt in inflation has been spurred by manufactured products, in turn impacted by rising input costs.

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The underlying risk of an inflation surge led by manufactured products, which is the group with the largest weightage in the Wholesale Price Index (WPI), is that it will provide a momentum to price increases and inflationary expectations that can’t easily be reversed. Especially since the government is yet to effect a long overdue increase in prices of fuel products such as diesel.

RBI’s latest households’ inflation expectation survey reports that it’s seen to rise 120 basis points (bps) over the next year, from the current perceived level of 11.5%. One basis point is one-hundredth of a percentage point.

Data released by the department of industrial policy and promotion showed core inflation, excluding food and fuel products, accelerated to 7.2% in May, compared with 6.2% in April and 7.3% in March.

Finance minister Pranab Mukherjee said in a release that high inflation posed some concerns that have to be addressed.

The Prime Minister’s economic adviser C. Rangarajan warned that India needed to tame inflation to achieve 9% economic growth in the medium term, before urging RBI to further tighten monetary conditions.

Similarly, the Organisation for Economic Co-operation and Development (OECD), which on Tuesday released its Economic Survey on India, while pointing out that the policy rate was still below the inflation rate, cautioned that Indian authorities need to remain vigilant against the risks of high inflation.

“Notwithstanding occasional spells of credit market pressure, further incremental monetary policy tightening is advisable to ensure inflation moderates and to prevent inflationary expectations becoming unanchored," OECD said.

RBI has increased its key policy rate nine times in the past 15 months to 7.25%.

The upside in May’s inflation rate came primarily from cotton textiles, edible oils, chemicals and transport equipment. “Looking at the sources of inflation, we see that price pressures are again becoming generalized. Also, a sharp move in manufacturing inflation in a month when global commodity prices stabilized shows that producers’ pricing power remains quite strong," said Samiran Chakraborty, head of regional research at Standard Chartered Bank.

Analysts expect the inflation rate to remain above 9% till October after which it may start moderating. “Overall, WPI inflation will continue to be in the 9-10% range for the next few months before easing to 7.5% by March 2012," said Rajeev Malik, senior economist at CLSA Asia-Pacific Markets. RBI expects inflation to be around 6% by March 2012.

OECD said in its survey that stabilization in international commodity prices should lead to a gradual decline in inflation over the course of 2011, adding that a positive external demand impulse from advanced economies poses a risk of inflationary pressures being stoked.

However, Kotak Mahindra Bank Ltd chief economist Indranil Pan said the peak of the inflation trajectory will depend on the timing of a diesel and cooking gas price hike, holding that the current inflation projections are based on the as sumption the government may not increase fuel prices. He added that there is no fear of the economy overheating as industrial activity is cooling off and capital inflows are being absorbed by a high current account deficit on the balance of payments.

Standard Chartered Bank’s Chakraborty said a 4 per litre increase in diesel price plus a 30 per cylinder increase in cooking gas prices would lead to around a 100 bps increase in the WPI inflation rate, including direct and indirect effects.

The wide divergence between provisional and final inflation figures has been a cause of concern. The March final inflation rate was revised up by 66 bps, lower than February’s revision of 123 bps.

Pronab Sen, principal adviser in the Planning Commission, said this divergence occurs whenever the base year is revised. The base year of WPI-based inflation was revised from 1993-94 to 2004-05 in October last year. “With the revision of the base year, new reporting units are added to the list from where data is collected. Such units are not in the habit of submitting data regularly. Hence, data comes late, which leads to high revisions. You may see this trend for a year or so until such units make it a habit of submitting data regularly," Sen said.

Analysts say there is little doubt that RBI will hike the policy rate by another 25 bps on 16 June. “The May inflation data should convincingly eliminate the surprising, but faint, expectation of a possible pause by RBI," said CLSA’s Malik. Factory output data released last week with a new base year of 2004-05 showed industrial growth moderating at a slower pace to 6.3% than expected.

“Growth is moderating, but not collapsing, therefore, RBI need not press the panic button on growth," Chakraborty said.

Graphics by Sandeep Bhatnagar/Mint

Reuters contributed to this story.