RBI chooses to be Cautious inspite of Lower CPI Inflation

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Key Takeaways from the CPI numbers…

  • CPI inflation for the month of November 2016 came in lower at a 2-year low of 3.63%. This compares very favourably with the 4.20% inflation reported in October 2016 and a much higher 5.41% CPI inflation reported in November 2016.
  • The component of CPI inflation that had traditionally put pressure on retail inflation was food inflation. This time around, food inflation came in at just 2.11% in November 2016 compared to 3.32% in October 2016 and a much higher 6.07% in November 2015.
  • The sharp fall in food inflation was largely driven by a good monsoon this year as well as a bumper Kharif output. In 2016, India received normal rainfall after 2 consecutive years of drought. This combined with the government managing the supply side bottlenecks better resulted in consistently lower food inflation.
  • As the chart above depicts, the food inflation has actually trended lower than overall inflation over the last 3 months. Putting it differently, retail inflation is now being driven more by non-food inflation rather than by food inflation.
  • The big challenge for the government is addressing oil prices. Brent crude has already moved up from $46/bbl to $54/bbl in the 2 weeks since the OPEC meeting at Vienna on November 30th. The supply agreement has raised hopes of demand exceeding supply that has resulted in prices of crude going up sharply in December.
  • Apart from the OPEC nations, non-OPEC nations like Russia, Mexico, Bahrain, Oman and Kazakhstan have also agreed to cut supply in solidarity with the OPEC. That will mean Brent Crude, probably, topping the $60/bbl mark. That could have larger ramifications for inflation. Since India imports 80% of its oil requirement, higher crude prices will result in imported inflation since oil has a very strong multiplier effect on inflation.
  • Within the CPI food basket, cereals and milk products saw inflation hovering around the median levels of 4-5%. This has prevented the inflation from running away too fast. The big improvement has been on the pulses front. After Tur Dal spooked overall inflation, we are seeing a more comfortable scenario with pulses inflation coming almost flat at 0.23% for the month of November 2016.
  • Among the more sensitive products, fruits inflation was flat while vegetables saw negative inflation to the tune of nearly -10.5%. In the past, tomatoes and onions have been the key contributors to food inflation. That trend seems to have been arrested with both vegetables and fruit prices trending downwards.
  • The one thing that the RBI and the government need to be cautious about is the base effect. Typically, the CPI inflation gets the benefit of the base effect from August to November. From December onwards, the base effect starts to wane and inflation starts to pick up once again. This is something the RBI and the macro policy makers need to be fully conscious of.
  • In terms of regional trends, rural inflation continues to rule well above the urban inflation; both in terms of food inflation and in terms of overall inflation. Among various states, higher inflation is visible in newly formed states like Telangana as well as in specific states like Delhi, West Bengal and Jharkhand.
  • CPI inflation may now need to be looked at in conjunction with the IIP numbers and the WPI numbers. There are two side effects one needs to understand here. While lower inflation is a good sign, the dividing line between low inflation and disinflation is quite hazy. With demonetization taking its toll on productivity, the government and the RBI need to ensure that the fall in inflation is an indicator of price stability and not of slowing output.
  • The CPI numbers also need to be understood in the light of the demonetization exercise undertaken from November 09th this year. While actual data on demonetization is yet to be released, the immediate reaction is that there has been a drastic reduction in footfalls and in consumer demand. This trend is more pronounced in the rural and semi-urban areas where cash transactions are much more in vogue. If the fall in inflation is an outcome of the slowdown caused by demonetization, then it may not be a very good indicator of economic health.
  • That brings us to the final question; how does this CPI number impact the RBI stance on rates? RBI may prefer to double check other sources of data before arriving at a decision on rates. Firstly, the impact of demonetization on inflation and output is yet to play out fully. Secondly, the RBI may look at other data points like WPI and IIP to gauge the full and holistic impact on the overall economy. Thirdly, the RBI will be watching out for oil prices and the dollar index. Both have the potential to export inflation into India and the RBI would be wary of that.

The lower CPI number is surely encouraging. However, at this of time there are too many unexplained variables. The next 2 months will give us a better idea of how the interplay of demonetization, inflation and growth play out. By February 2017 there should be greater clarity on all these parameters, which will enable the RBI to take a more dispassionate view on the India economic story.

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