Food and fuel are major concerns

Food inflation can be managed if rains are good. But if fuel prices rise, current account deficit will be a worry

Rising trends in food and fuel inflation and a more hawkish stance from the US Federal Reserve could lead to a rethink on India's interest rate policy. The RBI started cutting interest rates in January 2015 and it has knocked 150 basis points off policy rates in the last 16 months. It has generally been assumed that the RBI would continue cutting. But it may call a halt to this, or even start hiking if the Fed tightens US policy rates early than expected. The Fed's actions could therefore, have an adverse influence.

India's interest rate regime is based upon two policy rates. The higher, the so-called Repurchase Rate (Repo), is the rate at which the RBI lends money to banks. The lower policy rate is the Reverse Repo at which the RBI borrows money from banks.

The third lowest "rate" is the yield on government treasury bills. As far as an institutional lender is concerned, the T-Bill is the safest instrument in India and the yield-to-maturity is a key benchmark. Commercial interest rates set by banks add some sort of spread onto the

T-Bill yield. Commercial rates depend on the creditworthiness of the borrower, the operating efficiency of the bank, etc. Most commercial rates start at 5-6 per cent higher than Repo.

The Consumer Price Index (CPI) is used as the benchmark for inflation by the RBI. The Repo has run at an average premium of 1.8 per cent above the CPI's year-on-year rate of change since mid-2014. Hence, commercial rates have been at least 5-6 per cent higher than CPI, which is a large spread in terms of real interest.

Although nominal interest rates did reduce through calendar 2015 and 2016, the CPI may have fallen faster. The CPI fell below 5 per cent by March 2016. The Wholesale Price Index (WPI) also ran negative for 17 months in a row between November 2014-March 2016.

The inflation trend may be changing. The CPI was at 5.4 per cent in April 2016, up from 4.83 per cent in March. Food inflation was higher at 6.3 per cent.

Fuel inflation may pick up further. International crude prices have recovered a little. The Indian crude import basket now costs about $47/barrel, up from $27-28 in February. Core CPI inflation (minus food and fuels) is also trending up.

The "Laksman rekha" is 6 per cent CPI because the RBI targeted that level for January 2015. The RBI targets 5 per cent CPI for January 2017. At above 5 per cent, it is very unlikely to lower rates. If CPI moves above 6 per cent, the central bank may very likely, raise rates.

The WPI has also shifted into positive territory. In April 2016, it hit 0.34 per cent. This uptick is mainly due to food inflation. If the monsoons oblige, that worry will ease. But rising fuel prices could also drive inflation up anyhow. A recent advisory by Goldman Sachs suggested that the scenario of global crude oversupply was changing.

The US Federal Open Markets Committee considered rate hikes at its last meeting in late April, going by the minutes released last week. The next meeting is in mid-June and America's consumer inflation is also trending up. If USD policy rates are hiked, even by a token amount, currency equations change. The USD will harden and yields will rise in US bonds.

Risk-off investors will pull out of Emerging Markets and head into US Treasuries. In such circumstances, the rupee would be pushed down. The RBI may be forced to raise Repo to maintain the spread between USD and rupee returns.

Even if nominal rates are held at current levels, real interest rates may ease down since inflation is rising. Will cheaper credit induce more borrowing? Perhaps but that would again depend on perceptions of demand which brings us back to monsoon dependency. Assuming the monsoon does oblige, food-related inflation would come under control and rural demand would pick up.

So, food and fuel are two major baskets of concern. Food inflation will be manageable if the rains are good. But fuel-related inflation would be hard to control. If crude prices do rise, all the old worries about higher current account deficits, and higher fuel subsidies will resurface.

Market sentiment has been good since the Budget. The latest inflation data might lead to a change in sentiment. It does, at the least, ring an alarm bell.