Shifting contours of inflation

Shifting contours of inflation

Inflation pressures accentuated through the first quarter of 2011, with Wholesale Price Index (WPI) inflation touching 9.0% in March, considerably above market expectations. The January WPI number was also revised up to 9.4% from the provisional estimate of 8.2%. This is the second month in a row that the provisional WPI number has been revised upward by 1 percentage point or higher. Past data revision trends suggest that both February (8.3%) and March (9.0%) inflation numbers will likely be adjusted upward by another 100 basis points (bps) or so, pushing the inflation rate to double-digit trajectory.

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A striking feature of the recent inflation cycle has been its sticky nature. Since January 2010, WPI inflation has consistently stayed above the 8% mark, despite repeated rate hikes by the Reserve Bank of India (RBI), negligible pass-through of higher global oil prices, and a normal southwest monsoon in 2010. The trend is worse for Consumer Price Index (CPI) inflation (industrial workers), which has stayed above 8.0% since July 2008 (averaging 11.0% between then and February 2011). Another worrisome trend is the spillover of inflation pressure from food to non-food items.

Food inflation, the main catalyst in driving headline WPI inflation to double-digits in 2010 (food inflation averaged 17.9% that year), has eased in recent months. Food prices slid in February by a sizable 6.0% month-on-month (m-o-m), and since March the pace of moderation has continued albeit at a slower rate (-0.9% m-o-m). This should moderate in the coming months on a year-on-year (y-o-y) basis (to mid-single digits) purely on account of a favourable base effect, even if weekly food prices continue to register modest increases. For the rest of the year, the outlook for food prices will depend on the outcome of the southwest monsoon. Note that there is an asymmetrical bias in the impact of monsoon on food prices—while a good monsoon may not lead to a sharp fall in food inflation, as was witnessed in 2010, a bad monsoon will most definitely lead to a spike in prices.

While the risks related to food inflation will continue to linger until the full impact of the southwest monsoon is known, risks to the fuel and core inflation outlook have risen appreciably in the last few months. Until recently, pressure on core inflation (manufactured goods less processed food) had remained modest, but in March core inflation rose to 7.2%, significantly above its long-term average of 4.0%, indicating spillover from food/fuel to broader prices. Within manufactured goods, price pressures were recorded in almost all sub-groups in March (except leather and leather products), with the sharpest rise seen in items such as cotton textiles (+8.3% m-o-m, 27.5% y-o-y), man-made textiles (+2.8% m-o-m, 11.4% y-o-y), iron and semis (+2.3% m-o-m, 10.1%y-o-y), chemicals (+1.6% m-o-m, 6.6% y-o-y) and beverages and tobacco (+1.3% m-o-m, 7.3% y-o-y). With global commodity prices having risen substantially in recent months, and domestic growth drivers remaining sufficiently strong, it is natural for demand-side inflation to manifest.

In fuel, the inflation rate is at an uncomfortably high double-digit rate of 12.9%, despite the government keeping prices of key products such as diesel, LPG and kerosene unchanged since mid-2010. The policy to contain inflation, however, is adding pressure on the fiscal front, with under-recoveries of public sector oil marketing companies (OMCs) rising by the day. Preliminary estimates suggest that under-recoveries in FY11/12 could rise by 43% y-o-y ( 1 trillion) if global crude oil prices averaged around $100/barrel (see table). With the bulk of the under-recoveries (around 60%, 650 billion) expected to be funded by the government (apart from pending payments for FY10/11, around 200 billion), the fuel subsidy bill for FY11/12 could be substantially higher than currently budgeted ( 236 billion). If global crude oil prices averaged at a higher level (say $125/barrel), under-recoveries could rise to as high as 1.8 trillion in FY11/12, with the government’s subsidy bill rising close to 1.1 trillion.

The likely pressure on the fuel subsidy bill makes it clear that the government would have little choice but to hike fuel prices soon, thereby affecting the fuel as well as the overall inflation rate. A fuel price hike is most likely to take place sometime in May/June (after the state elections). Assuming a diesel price hike of 5-6%, coupled with a 10% staggered increase in petrol prices, this should push up WPI inflation by an incremental 100 bps in the coming months. LPG and kerosene price hikes are also warranted (as these items add the most to the under-recovery of OMCs) but that decision is likely to depend on the government’s relative comfort level on inflation vis-a-vis its resolve to maintain the fiscal deficit target of 4.6% of gross domestic product for FY11/12.

All in all, the expected fuel price hike (in diesel and petrol at the least) as well as the recent firming of core inflation are likely to keep WPI inflation elevated above the 8% mark for quite some time, despite probable moderation in food inflation. Given this worrisome outlook, RBI will likely continue with monetary tightening (another 75 bps rate hike in the next three months), in its effort to neutralize the prevailing negative real interest rate (measured as repo rate–WPI inflation) and control inflationary expectations.

Graphic by Ahmed Raza Khan/Mint

Kaushik Das is the India economist for Deutsche Bank AG

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