Lower CPI Inflation May Not Indicate a Rate Cut

Along expected lines, the CPI inflation for the month of January 2017 came in lower at 3.17%. This compares favourably with the 3.41% CPI inflation reported in the month of December 2016. What exactly are the key takeaways from the inflation numbers? More importantly, what does that imply for the rate outlook of the RBI? Will it result in a rate cut in the forthcoming monetary policy in April this year?

 

Food inflation was the key driver of lower CPI inflation…

 

The major driver of CPI inflation was sharply lower food inflation. The food inflation for the month of January 2017 came in at 0.53% and it has fallen sharply from a high of 8.35% in July 2016. What exactly has driven this sharp fall in food inflation? The reversal in food inflation started after the monsoon data started coming out. With a normal monsoon after 2 consecutive years of drought, the impact on food inflation immediately started to show. This can also be partly attributed to the base effect but the fact remains that the bumper Kharif production, which is expected to be almost 10% higher, has been the real driver for lower food prices post July. In fact, food inflation that was applying upward pressure on CPI inflation till July 2016 has now started applying downward pressure on overall CPI inflation.

 

How the specific components of CPI inflation behaved in January 2017…

 

As stated earlier, it was food inflation that drove the overall CPI inflation lower. Within the food basket, it was the negative inflation in vegetables and pulses that contributed to lower food inflation. It may be recollected that it was precisely vegetables like onions and tomatoes and pulses like Tur Dal and Udad Dal that had contributed to a sharp rise in food inflation prior to the 2016 monsoon season. There are two ways to look at this. The negative inflation in pulses (-15.62) and vegetables (-6.62%) may be seen as a reversal of the aberration in prices that we saw last year. To that extent this behaviour of prices is acceptable. This sharp cut in food prices could also be partly attributed to the steps taken by the current government to prevent hoarding and ensure smoother supply chain management of food.

 

Rural inflation and the demonetization angle…

 

For over the last 2 years, there was a sharp gap between rural inflation and urban inflation. Rural inflation was consistently much higher than urban inflation. This was partly due to higher demand in rural areas but was also attributed to supply bottlenecks. However, what has been seen in the recent past is a distinct fall in rural inflation and the gap between rural and urban inflation has been narrowing sharply. Exactly a year ago in January 2016, the urban inflation was at 4.81% while the rural inflation was much higher at 6.48%. In the previous month of December 2016, urban inflation was at 2.90% while rural inflation had narrowed to 3.83%. What we see in the last 1 month is that the urban inflation has stayed constant at 2.90% but rural inflation has fallen to 3.36%. Effectively, the entire fall in CPI inflation for Jan 2017 has been contributed by rural inflation. Why is that a worry? The biggest impact of demonetization was felt on the rural and semi-urban areas where the cash disposition led to a sharp demand crunch. One only hopes that demonetization has not caused any long term damage to rural demand. We will get greater clarity in the next couple of months once the remonetisation impact is more visible at a grass-root level!

 

So, where does that leave the RBI stance on repo rates?

 

We will get much greater clarity on this subject once the minutes of the Monetary Policy Committee are released on the 22nd of February. However, there are 5 key takeaways for the RBI in terms of its policy stance:

 

• Food inflation continues to fall sharply. That is good news, but the potential of food inflation to contribute to further fall in inflation may be limited. The worry for the RBI could be that non-core inflation items like clothing, housing and other services are still being sticky and not showing signs of abating.

 

• RBI needs to be convinced that remonetisation is leading to a revival in demand. Lower IIP numbers combined with weak CPI indicates that the pressure of demonetization is evident. However, rate cuts will make a difference only if remonetisation has begun to work.

 

• RBI is more likely to be worried about the sharp fall in rural inflation. That is an obvious outcome of weak rural and semi-urban demand and that may require fiscal policy measures rather than monetary policy measures.

 

• As long as non-core inflation remains sticky, the RBI may not be inclined to cut rates purely because the food inflation is down. The RBI may choose to wait and watch for more data points on growth and remonetisation before taking a call.

 

• In a volatile global scenario, the immediate priority of the government and the RBI is likely to be protecting the INR against any major risk-off shift by FPIs.

 

In a nutshell, the lower food inflation seems to be largely driven by weaker demand in non-urban pockets due to the lag effect of demonetization. The RBI may not see much point in cutting rates further unless remonetisation starts to play the liquidity balancing role satisfactorily.