CPI Inflation Comes in Lower; But Can it Sustain?

On the lines of the WPI inflation which was announced earlier during the day on 15^th November, the CPI inflation number which was announced later during the day also came in lower than the October 2015 figure. CPI inflation, which is a measure of retail consumer inflation, came in at 4.20% for October 2016, lower than the 4.39% (final estimates) reported in the month of September 2016. The chart below depicts the Monthly CPI and its key component, food inflation over the last 1 year. What is revealing about this chart is that the fall in CPI inflation since July 2016 has been largely driven by a very sharp fall in food inflation.

Food inflation drives CPI inflation lower

Food inflation has a unique importance in the Indian context for a variety of reasons. Firstly, food inflation tends to be sticky and takes longer to come down as compared to overall non-food inflation. Secondly, food inflation is the key metrics for the RBI to decide on the future trajectory of repo rates. When food inflation falls sharply and sustains at lower levels, it gives the RBI the much needed comfort level to follow a dovish monetary policy. Thirdly, food inflation is vulnerable to supply side bottlenecks. It has been seen in the case of pulses and vegetables that prices tend to be rigid even though there are efforts to increase supply. This time around the impact of a better Kharif crop has been clearly visible in food inflation with limited time lag. Lastly, year 2016 has seen near-normal monsoons after 2 years of drought. The Kharif crop output is also estimated to be sharply higher compared to last year. This will take away some of the sting of food inflation in the coming months. As Vaibhav Agrawal, Head of Research, Angel One summed it up, “Lower food inflation was the main reason for the moderation of CPI inflation to 4.2%.”

Breaking down the CPI basket

The real triggers for overall CPI inflation have always been within the Food inflation basket. The good news is that the four key drivers of food inflation viz. pulses, cereals fruits and vegetables are all well within control. In fact, vegetable inflation has gone into negative territory, although that could be more due to the preponderance of the base effect. The other 3 are hovering around the 4% mark. Over the last 1 year, it was pulses and vegetables that accounted for a bulk of the food inflation. These have largely come under control and that is an assurance that we may not have negative surprises on the food inflation front in the coming months. The only worry here seems to be that the rural inflation continues to be meaningfully higher by 124 basis points in terms of overall inflation and 153 basis points higher in case of food inflation. That has been the trend over the last 2 years, although the absolute rural inflation has been on a downtrend.

What does this augur for RBI rate stance in December 2016?

The RBI has consistently maintained its stance that rate trajectory will be based on the direction of CPI inflation and especially food inflation. To that extent the CPI and Food Inflation number for October 2016 seems to be supportive of a more dovish approach. However, it appears that the RBI may have front-ended its rate hike in October itself. Then there is the uncertainty over the Fed stance in December and hence the RBI may not be too keen to cut repo rates in their December Monetary review. Fed futures are already pricing in a probability of 80% that the Fed would hike rates in December 2016. Considering the sensitivity of global capital flows to rate differentials, the RBI may choose to maintain status quo in its December monetary review.

What does this augur for RBI rate trajectory in 2017?

The bigger question is what does this CPI and food inflation number augur for the future trajectory of repo rates in 2017? We need to view this in the light of the current drive to demonetize the currency of higher denominations. As an outcome of this demonetization, the banks are likely to be flush with liquidity, as is already evident in the first few days since the demonetization exercise started. This large infusion of liquidity into banks will be instrumental in suppressing yields at the shorter end of the curve. On the other hand, the weak CPI inflation number will be instrumental in suppressing yields at the long end of the yield curve. As Vaibhav Agrawal aptly summed it up, “Inflation could soften further as the demand side gets impacted by demonetization and this raises the probability of rate cuts.”

We expect that the Fed may hike rates by 25 basis points in December but subsequent rate hikes will be more carefully calibrated. With Trump proposing to invest $1 trillion into US infrastructure, the focus will be on ensuring that rates do not go too high. That will leave the RBI with substantial leeway to cut rates in 2017. That could be the icing on the cake for the Indian equity and debt markets.