Core inflation remains sticky

RBI’s rate rises drag GDP down, but robust demand keeps core inflation high.

The Reserve Bank of India’s battle against inflation is set to get tougher. While last month’s steep rate rise has managed to slow growth (as the fourth quarter GDP figures indicate), it hasn’t succeeded in taming inflation, thanks to the robust demand. In the last quarter of FY11, private consumption growth moderated only slightly to 8 per cent, due to solid growth in disposable incomes, while government consumption went up 4.9 per cent.

No wonder prices have remained high through May. Headline inflation jumped to 9.06 per cent for the month, above consensus estimates of 8.7 per cent. Core inflation (non-food manufacturing) jumped to 7.2 per cent year-on-year as against 6.2 per cent in April. Food prices are marginally down to 8.4 per cent from 8.7 per cent in April.

So, if growth is coming off, why aren’t the prices? The answer will vary from economist to economist. For obvious reasons, economists with conglomerates believe core inflation is up because of interest rates, fuel charges and other input prices. Their basic premise is that there is no excess demand and that rate rises will fuel inflation further, not tame it. Strong demand does not automatically translate into pricing power.

However, another school of thought believes inflation dynamics have become more complex and have shifted from supply to the demand side. What this essentially means is that, while supply-side constraints can be addressed to bring down prices of food and primary articles, strong demand will keep core inflation high. Leif Lybecker Eskesen, chief economist for India & Asean at HSBC Global Research, says: “Capacity is still very tight because demand remains in excess. Even as growth moderates in response to higher policy rates and the uncertainty associated with the elevated level of inflation, capacity will remain tight for a while still (until growth decelerates sufficiently and for an extended period).”

Core inflation could stay high, as a rise in diesel prices seems imminent. All of this spells more policy tightening and the next move will be at the June 16 monetary policy meeting. Broadly, while the case for 50 basis points looks compelling, the central bank may settle for 25 bps rise on Thursday, as global growth softens and domestic activity continues to cool. For equity markets, there’s not much in store, as high inflation and lower GDP growth has been factored in.