Policy rates may stay put

The recent rise in inflation can limit further monetary easing

Inflation concerns have reignited rather quickly, with the sharp rise in CPI inflation from 4.8 per cent in March 2016 to 5.8 per cent in May 2016. The prevailing firmness in food prices and the imposition of the krishi kalyan cess on taxable services from June 1, 2016, may well push the next two prints for CPI inflation close to 6.0 per cent, the upper end of the 2-6 per cent band enshrined in the Agreement on Monetary Policy Framework of the Government of India (GoI) and Reserve Bank of India (RBI).

Food prices — the culprit

Food prices were the chief culprit behind the recent flare-up of inflation. Retail food inflation hardened from 5.2 per cent in March 2016 to 7.6 per cent in May 2016, with lower production pushing up prices of pulses and sugar. Moreover, high temperatures adversely impacted the output and shelf life of fruits, vegetables, milk and non-vegetarian proteins, raising their prices.

After double-digit shortfalls in the last two years, monsoon rainfall is forecast to exceed the norm by 6 per cent in 2016. The monsoon onset in June 2016 was delayed by a week, and despite rapid progress in the last few days, the volume of rainfall remains around 20 per cent below normal.

Given the poor moisture content in the sub-soil, sowing may not immediately follow the first showers, but pick up after ground water levels are replenished once the monsoon gains strength. Improved sowing may dampen food prices, particularly if acreage expands for high-inflation items such as pulses, taking a cue from the rise in minimum support prices (MSPs) and bonuses announced by the Government.

Relief from the heat after rains set in would also douse prices of perishable items, even if their output is not correlated with the monsoon. However, sugar prices are unlikely to ease in the near term, given the outlook for production for the upcoming sugar year. Effective food management would aid in reining in inflation.

Commodity – the coolant

Higher global commodity prices and a weaker currency pose modest inflation risks. In particular, the average crude oil price has increased by more than 15 per cent over the last two months, which has led to a rise in the domestic retail prices of various fuels. Such changes are likely to be transmitted fairly quickly to WPI inflation, which has a substantial weight of crude and mineral oils, particularly those with non-administered prices.

However, the impact on CPI inflation would be muted, given the type of fuels and fares that are included in this index, and their relatively modest combined weight of 6.8 per cent in the retail basket.

For instance, subsidised fuels such as kerosene and LPG as well as bus/tram fares that tend to be closely regulated by State governments, together account for 3.0 per cent of the CPI Index; retail prices of such items are likely to display limited sensitivity to the uptick in crude oil prices.

The revenue impact notwithstanding, the Centre may choose to cut the excise duty on petrol and diesel, with a combined weight of 2.3 per cent in the CPI Index, to soften the inflationary pressure arising from an uptrend in crude oil prices.

Pay hike – the risk

The upcoming implementation of pay revision for Central government employees remains a risk to the RBI’s target of curtailing CPI inflation at 5.0 per cent in March 2017. The impact of the Seventh Central Pay Commission recommendations on the Union and Railway Budgets in 2016-17 is estimated at ₹1,021 billion or around 0.65 per cent of GDP. In addition, various State governments may revise pay scales over the next two years.

Higher house rent allowance to government employees would directly boost the housing sub-index of the CPI. Moreover, the expected pick-up in consumption related to the pay revision would indirectly affect CPI inflation. In particular, supply constraints for services such as education and health, which are non-tradable, would keep prices sticky and prevent an easing of households’ inflationary expectations.

On the other hand, moderate capacity utilisation levels in several sectors would prevent a sharp increase in prices. The RBI has indicated that it would look through some of the inflationary aspects of the pay revision.

Nevertheless, under the prevailing inflation targeting framework, ICRA expects additional easing in 2016 to be limited to 25 bps, without delving into speculation on whether the next RBI Governor would be hawkish or dovish and whether the monetary policy committee will be in place before the next policy review.

With the rate easing cycle in India close to its end, FIIs would demonstrate limited interest in investing in Indian debt in the immediate term, despite the impending increase in limits in Central and state government securities by an aggregate ₹135 billion in July 2016.

Investor outlook

Moreover, global trends such as the post-Brexit uncertainty and rate hikes by the US Federal Reserve may further curtail FII interest in Indian debt.

On the other hand, incremental FII equity inflows will be guided by the improvement in corporate earnings which will, in turn, reflect the uptick in rural demand and sustenance of urban demand.

Evidence that the pace of investment by the private sector is strengthening, unlikely to become visible until the second half of this fiscal, would also play a crucial role in guiding investor sentiments.

The writer is Senior Economist, ICRA

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