Graphic: Yogesh Kumar/Mint

Graphic: Yogesh Kumar/Mint

Inflation settles for a lower peak; demand-side pressure remains

Inflation settles for a lower peak; demand-side pressure remains

The Wholesale Price Index (WPI)-based inflation came in at approximately 9.9% year-on-year (y-o-y) for March (same as in the previous month), staying a notch lower than expectations.

Graphic: Yogesh Kumar/Mint

On the whole, however, slower passage of excise and customs duties on to manufacturing products was largely responsible for a lower-than-expected headline inflation number. In addition, prices for certain commodities (such as steel) seem to have been under-reported vis-a-vis actual on-ground price movements. Accordingly, a final revision of March numbers is likely to place the headline inflation somewhat higher.

Amid continuous government initiatives to rein in farm prices, a decent winter crop and projection of a normal monsoon in 2010, there have been early signs of softening of food price inflation. Moreover, April onwards, adversity of the base effect will also start waning. However, the only concern currently seems to stem from the likelihood of demand-side pressures. On the whole, we believe, the current hump in the inflation trajectory will be shortlived with the current month likely to be the peak. After April, WPI inflation is expected to start a gradual march downwards with a larger part of the second half of 2010 witnessing a headline number of approximately 7% y-o-y.

In March, the Reserve Bank of India (RBI) had resorted to an unexpected hike in policy rates to tackle inflation expectations. Hike in policy rates by at least another 25 basis points (bps) during RBI’s policy announcement next week is almost certain. Financial markets are, in fact, factoring in even stronger tightening (either cash reserve ratio hike of 25 bps or policy rate hike by 50 bps). However, a tightening at the moment will not be a shocker as hike in policy rates will indicate RBI’s continued confidence in the economic recovery. Even after the first few hikes, policy rates will stay far below their “steady-state" levels.

For January, the inflation estimate was revised upwards to about 9.44% y-o-y from about 8.56% reported earlier.

Among manufactured products, fall in the food products’ index was led by decline in prices of sugar, while most of the other indices continued to face higher prices, which partly reflects passing of higher excise and customs duties, in addition to a pick-up in economic activity.

Within the fuel index, higher prices of petrol, diesel and aviation turbine fuel, following a fuel price hike announced in the budget, drove the index higher.

The actual rise in consumer-level prices is steadily reflecting in the Consumer Price Index (CPI)-based inflation indices. Weights of the fuel group and metals are significantly less across CPI segments. With food articles having maximum weightage in consumer price indices, CPI-based inflation has remained stubborn. From February, however, there were some early signs of softening in CPI.

The Union Budget has set the Centre’s net borrowing target for FY11 at approximately Rs350 crore, which is slightly lower than FY10 levels. Since most of this borrowing will be front-ended (as in FY10), there will be constant pressure on yields in the short term.

Along with this as credit growth gradually picks up and RBI gradually reverses its monetary expansion stance, there will be constant pressure on the overall interest rate spectrum. Having said that, we do not expect the 10-year yield to shoot up and sustain beyond the approximately 8.20-8.40% range. In our view, there will be significant buying support at those levels. We also expect steady capital flows in India during the next fiscal, which will also be a cushion for domestic liquidity.

At the global level, concerns over inflation have gradually started drawing the attention of the central bank’s policymakers. With growth firmly setting in, several emerging economies have started reversing their easy monetary policy stances.

Among the developed world, Singapore, proclaiming that it had fully recovered the output lost during the recession, resorted to directly tackling its inflation concerns by allowing its currency to appreciate. Meanwhile, other governments in the developed world have preferred to be on the side of caution than risking growth recovery.