Food prices must decline sharply to avoid interest rate hikes | Mint
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Business News/ Market / Mark-to-market/  Food prices must decline sharply to avoid interest rate hikes
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Food prices must decline sharply to avoid interest rate hikes

Odds are skewed in favour of rising policy rates, unless food and fuel inflation comes down drastically

If food and fuel inflation were to come down sharply to 5%, Credit Suisse computes that a 90 basis point rise in the repo rate will be needed for the CPI to come down to 6%. Photo: Pradeep Guar/MintPremium
If food and fuel inflation were to come down sharply to 5%, Credit Suisse computes that a 90 basis point rise in the repo rate will be needed for the CPI to come down to 6%. Photo: Pradeep Guar/Mint

Ever since the Urjit Patel panel report was made public, the fear in the market has been that the central bank will target inflation to the exclusion of everything else. In a speech last Wednesday, governor Raghuram Rajan allayed that fear by saying that the Reserve Bank of India (RBI) won’t “administer shock therapy" to a weak economy. He has also turned on those who say that the RBI is not doing enough by pointing to the recession in the US when Federal Reserve chairman Paul Volcker rapidly raised rates. In sum, Rajan has tried to give the impression that he is steering a middle path, by choosing to target a slow and steady fall in inflation, rather than go for the jugular.

This middle path is also the cornerstone of the Urjit Patel panel suggestions—8% Consumer Price Index (CPI)-based inflation by January 2015, 6% by January 2016 and 4% (with a two percentage point band) thereafter. The question is: by how much will RBI have to raise the repo rate to reach those targets?

The answer depends a lot on the level of food and fuel inflation, which are far from a pure monetary phenomenon in India, points out an analysis by Credit Suisse. Food and fuel prices have a 57% weight in the CPI. Therefore, for overall CPI to reach the targeted levels, this component has to come down, else it will require a dramatic fall in core (or non-food and fuel) inflation, which in turn means that growth will have to be severely curbed.

For the CPI to hit 6%, when food and fuel inflation hovers around 10%, core inflation has to go down to 0.7%. That, as Credit Suisse estimates show, will require a massive nine percentage point increase in the policy rate, almost unimaginable. It will, of course, wreck the economy.

Putting things in context, in January, retail inflation for food was 9.9%, for fuel 6.5%, while headline consumer price inflation was 8.8%. Core CPI (excluding food and fuel) was 8.1%. True, food inflation had come down in January, but this is mainly a seasonal phenomenon. This component has averaged 9% since 2005. And inflationary expectations still remain high with 80% of respondents in the RBI survey expecting double-digit inflation a year ahead. If growth starts to pick up, it will mean additional pressure on core inflation unless the supply side improves.

In any case, even if food and fuel inflation were to come down sharply to 5%, Credit Suisse computes that a 90 basis point rise in the repo rate will be needed for the CPI to come down to 6%. One basis point is one-hundredth of a percentage point. That indicates the odds are skewed in favour of rising policy rates in the next couple of years, unless food and fuel inflation comes down drastically.

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Published: 27 Feb 2014, 07:35 PM IST
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