A further decline in vegetable prices and the expectation of a healthy rabi harvest to result in CPI-combined moderating to 8.5% in February 2014-ICRA

After peaking at 11.2% in November 2013, CPI-combined (for urban and rural areas) eased to a two-year low 8.8% in January 2014 in year-on-year (y-o-y) terms, led by a correction in vegetable prices. ICRA expects a further decline in vegetable prices and the expectation of a healthy rabi harvest to result in CPI-combined moderating to 8.5% in February 2014. This is only moderately higher than the target of 8.0% for December 2014 enshrined in the Report of the Expert Committee to Revise and Strengthen the Monetary Policy Framework released recently by the Reserve Bank of India (RBI). However, a number of factors are likely to keep retail inflation rigid in this calendar year, which would preclude monetary easing in the near term in ICRA's view.

While the Second Advance Estimates of crop production indicated a record-high rabi harvest of most major crops in 2013-14, heavy rainfall in the last two weeks has damaged crops over parts of the country, which would arrest the recent decline in food prices in the ongoing month. Additionally, the innate demand-supply gaps and supply chain inefficiencies are likely to result in food inflation remaining sticky over the course of this calendar year.

Moreover, early indications of an unfavourable monsoon in 2014 have emerged as a key risk factor to the CPI trajectory. With a clearer picture on the magnitude, temporal dispersion and geographic spread of rainfall as well as its impact on sowing of various crops likely to emerge only by July-August 2014, monetary easing is unlikely in the intervening period, even if CPI inflation eases to 8.0-8.5%.

Although supply-demand dynamics for crude oil appear to be easing with higher energy supplies in Mexico, the US (shale gas) and some normalisation in relations with Iran, prices may rise intermittently in the event of any geo-political tensions, such as the unrest in Ukraine over the recent weeks. Moreover, any movement in the INR-USD exchange rate would impact the price of the crude oil basket in Rupee terms, as well as extent of domestic inflationary pressures. At present, under-recovery related to the retail sale of diesel remains substantial at Rs. 8.37/litre for the fortnight of March 1-15, 2014, highlighting the considerable suppressed inflation in the economy. Overall, policy decisions regarding the revisions in the retail price of diesel, as well as subsidies on LPG and modifications in electricity tariffs would affect the inflation trajectory in 2014.

Moreover, CPI-core is likely to display a limited moderation as services inflation would remain persistent on account of wage inflation. Additionally, the non-tradable nature of some services affords higher pricing power to producers, enabling a greater pass through of input price pressures to final prices, even when domestic demand is subdued.

In the absence of shocks in commodity and food prices, retail inflation could ease to around 8% by December 2014, in line with the target. However, an unfavourable monsoon could keep average CPI in 2014 close to the ~10% recorded in 2013. Accordingly, ICRA expects the monetary policy stance to remain unchanged in the near term, keeping interest rates elevated.

CPI-Combined Proposed As Nominal Anchor Of Monetary Policy:

The Report of the Expert Committee to Revise and Strengthen the Monetary Policy Framework released in January 2014 recommended that CPI-combined should be the new inflation anchor for the Reserve Bank of India (RBI). This should be brought down to 8% in 12 months and 6% in 24 months, after which the recommended target of 4% +/-2% should be formally adopted. Inability to achieve this target for three successive quarters would be classified as failure to establish and achieve the nominal anchor.

The chief rationale behind adopting CPI-combined as the nominal anchor is that inflationary expectations and therefore, wage reset demands are influenced by the prices of the entire basket of consumer goods, including food items, that the consumer experiences at the retail level. This enhances the appropriateness of CPI-combined as the nominal anchor as compared to its subset excluding food items and fuel & light (CPI-core), which comprises only 41% of the CPI. Moreover, WPI-core (non-food manufactured products; 55% of the WPI), includes several industrial inputs that are not directly consumed by households, rendering it unsuitable as the monetary policy anchor. Furthermore, savings decisions are impacted by real interest rates, after taking into account the CPI, which is more relevant to households than the WPI.

However, prices of several components of CPI-combined, particularly food items and to a smaller extent services, are inherently sticky and are unresponsive to changes in monetary policy. Other key issues with using the CPI-combined as the nominal anchor include its short history (introduced in January 2011) and limited disclosure of weightages and price movements of its sub-components (23 sub-groups) as compared to the WPI (676 items), which diminish the analytical usefulness of the data being disseminated.

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