Inflation: Roadmap through the storm

1H10 inflation spike, Jan RBI hike, loan rates up 2HFY11-
We chart a roadmap to navigate our long-expected inflation spike that should
spark off with Monday’s 4.1% read. This also flags the first of three “battles of
nerves” we expect investors will face in 2010. An inflation scare could heat the
winter on agflation and the bottoming out of commodity prices. In response, the
RBI will likely hike by January, to rein in 5% inflation expectations, as growth risks
recede. We expect both pressures, however, to cool by June if the next monsoon
is normal. In our view, all should end well. Lending rates, which really matter for
growth, are unlikely to go up till October with both credit and gilt markets already
pricing in RBI action.
A winter of discontent, as WPI inflation hits 8% by March
We expect inflation concerns to flare up in the winter. WPI inflation, after all, should
flash past 4% in November (Monday) and 6% in December to an above consensus
8.7% in March. January 14 could thus show December inflation to have not only
crossed the RBI’s normal 5-5.5% comfort zone but also its more “relaxed” 6% end-
March target. For detailed analysis, find our last inflation report here.
7+% growth + inflation spike = January RBI CRR, rate hikes
We expect the RBI to hike the CRR by 50bp and policy rates by 25bp by January
to rein in inflation expectations. Given receding growth risks, pressures will likely
mount on Delhi ‘to do something’ at a time of high monetary expansion. The
growth impact, after all, is unlikely to be very material with credit and gilt markets
already pricing in some RBI action. Do find our last rates report here.
1Q10: Manufacturing to replace agflation as inflation driver
We expect “is-inflation-spreading?” concerns to peak in early ’10 as the bottoming
out of global commodity–fuel, metals–prices replaces Drought 09 as the key driver
of inflation. In our view, the worst of agflation is over. The next leg of inflation will
thus be driven by fuel and manufacturing. We estimate their share to shoot up to
45% of overall inflation by March from the current (-)180%.
CPI inflation amidst surplus liquidity to fuel inflation concerns
Inflation jitters will likely be aggravated–unnecessarily, in our view–by sustained
high CPI inflation at a time of high monetary expansion. India’s food-laden CPI
inflation dynamics, after all, largely reflect monsoon shocks rather than the more
conventional drivers like liquidity and corporate pricing power. Yet, doubting
Thomases will ask, could high CPI inflation not destabilize inflation expectations?
Inflation expected to cool off in the summer, El Nino willing
We expect inflation to subside to 5% levels by July if rains douse agflation. The
Australian weather bureau does forecast that the El Nino, the warming of the
Pacific that disrupts rains, would reverse by March. Monetary expansion should
also continue to moderate, especially if the RBI hikes CRR. In short, we believe
inflation expectations would hold, as the Indian public is used to inflation spikes.


Inflation: Roadmap through the storm
We chart a roadmap to navigate our long-expected inflation spike that should spark
off with Monday’s 4.1% read. This also flags the first of three “battles of nerves” we
expect investors will face in 2010. An inflation scare could heat the winter on agflation
and the bottoming out of commodity prices. In response, the RBI will likely hike by
January to rein in 5% inflation expectations, as growth risks recede. We expect both
pressures, however, to cool by June if the next monsoon is normal. In our view, all
should end well. Lending rates, which really matter for growth, are unlikely to go up till
October with both credit and gilt markets already pricing in RBI action. Incidentally, do
read our November 3 battles of nerves: inflation, "W", rates report.
A winter of discontent, WPI inflation to hit 8% by March
We expect inflation concerns to flare up in the winter. Wholesale price index
(WPI) inflation, after all, should flash past 4% in November (on Monday) and 6%
in December to an above consensus 8.7% in March 10 (Chart 1). January 14
could thus show December inflation to have not only crossed the RBI’s normal 5-
5.5% comfort zone but also its more “relaxed” 6% end-March 10 target. Even our
‘contextual’ core inflation (ie, inflation, adjusted for agro, metal and oil shocks) will
likely hit 5% in March.


7+% growth + inflation spike = January RBI CRR, rate hikes
We expect the RBI to hike the cash reserve ratio (CRR) by 50bp and policy rates
by 25bp by January to rein in inflation expectations (Chart 2). Given receding
growth risks, pressures will likely mount on Delhi ‘to do something’ at a time of
high monetary expansion (Chart 3). The growth impact, after all, should not be
very material as credit and gilt markets have already priced in some RBI action.
In the past, Indian policy makers have typically progressed from denial to
monetary action during inflation spikes. In fact, hawks have already begun
feeding on food inflation! Inflation expectations are “…like a dam…”, recently
warned C. Rangarajan, chairman of the Prime Minister’s Council of Economic
Advisers, “…if there is a breach, water will flow through it…”.
1Q10: Manufacturing to replace agflation as inflation driver
We expect “is-inflation-spreading?” concerns to peak in early ’10 as the global
bottoming out of commodity prices replaces Drought 09 as the key driver of
inflation. In our view, the worst of agflation is over (Charts 4-12, Table 3). The
next leg of inflation will be driven by manufacturing and fuel in 1H10 (Table 4).
Sustained double-digit CPI inflation at a time of surplus liquidity will also add to
concerns–misplaced, in our view–of spiraling inflation expectations.


Agflation: Peaking off as autumn supplies come in
We would expect agflation to peak off in the winter. In times of drought, agro
prices typically shoot up as the news of poor rains fuel speculation in food
commodities (Chart 13). They generally cool off in the winter as the supplies from
the autumn harvest come in and Delhi – always belatedly, alas! – releases buffer
stocks and imports food. It is true that the inflationary impact of Drought 02
persisted till March 03. Given that the winter - rabi - wheat cropping looks set to
be better than Drought 02’s rabi, March 10 should be relatively more benign.


Sweet surrender? Sugarcane MSP hike not priced, hits 50bp
We find that the government is yet to price in the 32% hike in sugarcane minimum
support (MSP) prices to Rs108/quintal. The government’s newly introduced fair
and remunerative price (FRP) is even higher at Rs129/quintal. Incorporating the
hike in sugar MSP in the WPI would push up inflation by an additional 50bp.
Bottoming out of commodity prices to drive inflation in 1Q10
We expect the next leg of inflation to be driven by the bottoming out of global
commodity prices from post-Lehman shock lows that will stretch till June 10
(Charts 14-22). This, in turn, will likely be reflected in higher y-o-y manufacturing
price inflation. Indian corporates, after all, enjoy greater pricing power relative to
their peers, with growth – 7.7% BofAMLe - likely to revert to the economy’s
potential of 7.5% next year


Second-round effects to sharpen domestic inflation spike
As base effects end in December, the rebound in y-o-y manufacturing inflation will
likely be led by a turnaround in metal price and by extension, machinery price
inflation (Charts 23-25). Chemicals and chemical product prices should also head
up as the rebound in crude prices pushes up domestic fuel costs (Chart 26).
High CPI to provoke concerns of rising inflation expectations
Inflation jitters will likely be aggravated – unnecessarily, in our view - by high CPI
inflation (Charts 27-28). India’s food-laden CPI inflation, after all, essentially
reflects monsoon shocks rather than the more conventional drivers of liquidity and
corporate pricing power. Yet, doubting Thomases will surely ask, could sustained
high CPI inflation not destabilize 5% inflation expectations1?
Amidst liquidity overhang of 20% monetary expansion
And, what price liquidity?, the hawks may question. Monetary expansion, at 20%
for the past 2 years, has been indubitably excessive (Chart 29). And empirical
work suggests that excessive monetary growth spills over into inflation with a lag
of 2 years. It is for this reason that we expect the RBI to tighten CRR in January.


Inflation expected to cool off in the summer, if rains are normal
We still believe all should end well if rains douse agflation next year. Both sets of
inflationary pressures – agflation and normalization of commodity prices – should
cool by June if the next monsoon is normal. Besides, monetary expansion should
also continue to moderate, especially if the RBI hikes CRR (Chart 30). Finally, we
believe 5% inflation expectations would hold, as the Indian public is used to
violent inflation spikes on agro, fuel and metal shocks. Chart 31 shows that this is
the fifth inflation spike – each lasting 4-10 months - since 2002.
Our inflation forecasts suggest that base effects of this year’s agflation should
actually pull inflation below 5% levels by September. Inflation should revert back
to the RBI’s 5-5.5% comfort zone by early ’11, especially if Delhi hikes petrol and
diesel prices by 10% in mid-10 as we expect.
El Nino forecast to reverse by March
Will it really rain next year? As of writing, the Australian weather bureau forecasts
that the El Nino, the warming of the Pacific that disrupts the Indian monsoon,
should reverse by March 10. Chart 32 shows that an increase in the Southern
Oscillation Index (ie, a reduction in El Nino conditions) correlates well with agro
growth, and by extension, inversely with agflation.
Commodity price inflation expected to abate by June
We expect the process of bottoming out of global commodity prices from post-
Lehman shock lows to run its course in the next six months. Our commodity
strategists do not forecast significant immediate hardening beyond 2H09 levels.
This, in turn, should ease “imported inflation” pressures on Indian inflation by
September.
A simple numerical example about crude prices should help underscore our point
about the commodity price spike ahead. Oil price inflation has been falling 30-
50% after the Lehman shock pulled Dated Brent prices down to US$42/bbl last
December from US$112/bbl in August 08. Dated Brent recovered to US$60+/bbl
in May 09. This implies that oil price inflation will jump 50% during December-
April 10. If Dated Brent stabilizes around US$75/bbl, as our commodities team
expects, we expect oil price inflation will abate to 10% after May 10.

Indian Economy - Q2 FY10 update

India GDP growth rates. RBI estimate for the year is at 6.5% for FY10.


The Gross Domestic Product (GDP) expanded during the second quarter (July – September) of the fiscal year 2010 by 7.9%. The key drivers for this strong figure are:

• Pickup in manufacturing sector (9.2% vs 5.1%)
• Increased government expenditure 
• Lower interest rates
• Higher government salaries & pay commission arrears
• Increased incomes especially in the rural areas due to greater social spending and high farm goods prices
• Modest growth in farm output despite drought (0.9% vs 2.7%)

Better than expected GDP growth rate could lead to 

Government withdrawing stimulus – certainly beginning the phasing out over next few months

RBI tightening interest rates soon

GDP growth rate concerns

• Performance of agriculture due to poor monsoon
• Food price Inflation
• Exports (Contributing a fifth of India’s GDP)
• Fiscal deficit