A worrying macro-economic trend

CPI and WPI inflation posted downside surprises, converging at 2.2% in May 2017

The high frequency data released this month provided some surprises, with industrial output exceeding the consensus expectations and inflation falling well below the median forecasts.

The new series of the Index of Industrial Production (IIP) with a revised base of FY2012, was released by the Central Statistics Office (CSO) in May 2017. This has an improved coverage of 809 items, which is expected to provide an updated and accurate representation of monthly volume growth in the industrial sector.

According to the FY2012 series, industrial growth stood at 3.1 per cent in year-on-year (YoY) terms in April 2017, somewhat higher than expected. Disaggregated data offers mixed cues, including a base-effect led contraction in capital goods (1.3 per cent) and consumer durables (6.0 per cent) in April 2017, with the latter in stark contrast to the 8.3 per cent growth in consumer non-durables.

In fact, consumer durables output has contracted consistently since December 2016, whereas consumer non-durables have posted a robust 7.4 per cent growth over this period, providing no clear conclusion regarding the strength of consumption demand.

A disconcerting trend has emerged in the form of the revision in the pace of IIP growth for March 2017 to 3.8 per cent, from the initial assessment of 2.7 per cent. This was led by a sharp turnaround in the performance of capital goods to an expansion of 9.6 per cent from the initial forecast of a 1.0 per cent contraction.

The revision for March 2017, coupled with the sharp deceleration to a 1.3 per cent de-growth in April 2017, has raised the fear that the capital goods sub-index may continue to be plagued by volatility even in the new IIP series, impairing its usefulness to policymakers in gauging trends in investment activity.

After five consecutive months of sub-4 per cent industrial growth, a mixed picture has emerged for May 2017, with a pick-up in electricity generation, automobile production and consumption of various fuels, in contrast to a continued contraction in the output of Coal India.

During June 2017, the transition to GST is likely to temporarily weigh upon production, as some wholesalers and retailers may choose to enter the GST era with lighter inventories. However, we expect an equivalent upswing in Q2 FY2018, led by restocking of inventory to normal levels.

The CPI and WPI inflation posted downside surprises, converging at a low 2.2 per cent in May 2017, dampened by disinflation in vegetables and pulses. While this is positive for consumers, it is a worrisome macroeconomic trend. Assuring remunerative prices to farmers is important to sustain their income levels and interest in growing such crops.

Early trends for kharif sowing indicate a 39 per cent YoY decline in the area under pulses on June 16, 2017. Given the disinflation for pulses, it is unclear whether the 7-8 per cent increase in minimum support prices (MSP) for such crops would be adequate to convince farmers to ramp up sowing, given the limited public procurement of pulses at the MSP. The kharif sowing pattern would be crucial to gauge whether the prevailing low prices of pulses would sustain.

The monsoon season has kicked off on a positive note, food prices remain weak on a seasonally adjusted basis in June 2017 and the positive base effect for food inflation would continue till July 2017. We expect the CPI inflation to remain around 2 per cent for these two months, which is the lower threshold of the RBI’s inflation target band of 2-6 per cent. Based on this, there is a high likelihood of a 25 bps repo rate cut in the next bi-monthly meeting of the Monetary Policy Committee (MPC) to be held in August 2017. However, after parsing the minutes of their June 2017 meeting, we do not expect the Committee to unanimously vote for a rate cut in August 2017.

The impact of the distribution of rainfall and rise in MSPs on the sowing pattern, and the extent to which prices are revised amid the transition to GST, would influence inflation from July 2017 onward. Regardless, a reversal of the favourable base effect would push the CPI inflation above 4.0 per cent during H2 FY2018. Accordingly, we do not expect the rate cut cycle to continue in H2 FY2018.

The writer is Principal Economist, ICRA Limited

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