India Ratings and Research (Ind-Ra) expects one more 25bp rate cut in FY17 on account of the tweak in monetary policy stance and easing of retail and wholesale inflation. The change in the Reserve Bank of India's (RBI) policy stance with respect to the reduction in real interest to 1.25% from the 1.5%-2.0% range coupled with extending the time to achieve 4% inflation by three years (to March 2021 from March 2018) has provided RBI additional space for monetary easing in the near-term.
Consumer Price Index (CPI) came in at 4.3% in September 2016 as against Ind-Ra's forecast of 4.6%. Wholesale Price Index (WPI) moderated to 3.6% in September from 3.7% in the previous month. Both CPI and WPI moderated in September primarily led by softening food price inflation. The trend is along expected lines and Ind-Ra believes it is likely to continue in the next month.
Retail food inflation (excluding non-alcoholic beverages and prepared meals) moderated to 3.88%yoy in September 2016 from 5.91% in the previous month. This was because of a sharp decline in the prices of vegetables and pulses. Pulses inflation moderated to 14.3% in September 2016 (August 2016: 21.9%) while vegetable prices contracted 7.2% (1%). Prices of cereals, eggs, sugar and fruits, with a weightage of 14.35% in CPI, however increased in September 2016.
Lower retail inflation is indeed a reason for cheer, particularly when the festival season is round the corner; however, there are few pressure points that need attention such as i) rising trend in cereal prices, ii) rise in the prices of transport and communication services and iii) the likely impact of house rent allowance as and when announcement on allowance is made by the government. The other area of concern with respect to retail inflation is a sustained higher inflation in rural areas than urban areas. Rural CPI came in at 5% as against 3.6% urban CPI in September 2016.
While wholesale inflation has remained benign, pressure is emerging from fuel, power, light and lubricants group (September 2016: 5.6%, August 2016: 1.6%). Inflation of mineral oils group jumped to 10% in September from 3.4% in August 2016. Core (non-food) inflation after remaining in negative territory from March 2015 to June 2016 has turned positive since July 2016. Positive core inflation suggests some improvement in demand and pricing power; however, it is too early to term this as a demand turnaround.
Lower inflation cements market expectation of a rate cut and is, therefore, likely to keep bond market sentiment buoyed - with risks emerging from the Fed rate hike probability and a potential surge in oil price. While government bonds are likely to remain in focus, the preference could shift to highly rated corporate bonds and state development loans as investors rush to capture yields. This opens up the possibility of narrowing of credit and duration spread over the coming months.
In the medium term, the rupee will continue to be supported by fundamental drivers; while short-term movement will be guided by corporate earnings and global risk appetite. The flows' position has favoured the equity segment over the debt market for most of 2016. These flows will be impacted as the Fed moves closer to hiking rates while the concern over foreign currency non-resident (FCNR B) deposits redemption will pose volatility risks. Pertinently, a sudden shift in global financial conditions could pose risks for the currency as spreads between global yields and domestic yields have narrowed.
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