Moderating Retail Inflation Raises Monetary Easing Hopes; Poor IIP Reflects Sluggish Investment

The sharp fall in retail inflation in August 2016 has accentuated the rate cut proposition in the next quarter itself. However, it should be taken with a pinch of salt as a large part of food inflation is structural in nature, says India Ratings and Research (Ind-Ra). The retail inflation for August 2016 at 5.05%, came in lower than Ind-Ra's expectation of 5.30%, primarily driven by a sharp decline in food prices.

This has made the central bank's target of bringing retail price inflation down to 5.0% by March 2017 achievable; however, it may be early to rejoice given the baffling behaviour of retail inflation in the past. The cyclical components either aggravate or soften it as is evident from the movement in wholesale prices. Wholesale food price inflation was 5.3% during FY96-FY05 but increased to 9.2% during FY06-FY16. Clearly, the fight on the inflation front, particularly food inflation, is far from over.

 

Ind-Ra further opines the industrial growth will not return to a sustained and high growth path so long as excess capacity in the manufacturing sector remains and private sector investment cycle does not revive. The Index of Industrial Production (IIP) contracted 2.4% in July 2016 as against the growth of 2.0%yoy in June and was much lower than Ind-Ra's expectation of 1.2%.

The agency believes scope for the Reserve Bank of India's (RBI) action on rate front appears skewed towards December policy review than October 2016, although the sharp fall in inflation from 6.1% in July 2016 is likely to accentuate the expectation of rate cut in the October policy review itself. The maturity of large FCNR B (foreign currency non-resident) deposits worth USD26bn, which is coming due in the next two months, is likely to be the litmus test for the currency as well as for the RBI. Moreover, the RBI would have better clarity on the retail inflation trajectory for the last quarter of the fiscal, US electoral outcomes and Federal Reserve rate trajectory by December 2016.

The IIP data for July has further reinforced the volatility in factory output. The IIP growth had turned positive in February and March 2016 but turned negative in April 2016. IIP witnessed a broad-based weakness in July 2016 with sharp growth moderation in mining and electricity, while manufacturing output (75.5% weight in IIP) contracted 3.4% in July 2016 (June: 0.7% yoy). The disconnect between IIP and industrial gross value added (GVA) data is making it increasingly difficult to discern the sectoral as well as overall industrial and manufacturing output growth trend.

Manufacturing growth according to IIP data was negative 0.8% while GVA in manufacturing was 9.1% in 1QFY17. It is true that the two are strictly not comparable as the former measures output while the latter measures value added. Nevertheless, such a divergence is inexplicable and, increasingly, IIP is failing to measure the manufacturing or industrial growth in the economy. The base year used for IIP calculation is 2004-05, while industrial GVA is based on 2011-12 prices. The use of 2004-05 means a lot of data relating to industrial/manufacturing output is not captured by the IIP.

At the use-base level, capital goods output continued its negative trend. Capital goods output contracted 29.6% yoy in July 2016 against a contraction of 16.3% yoy in June 2016. This reinforces the lacklustre investment demand in the economy. Basic and intermediate goods continued with the positive trend but growth rates moderated to 2.0% (June: 5.8%) and 3.4% (June: 5.7%) in July 2016. Consumer durables maintained the positive growth trend. Consumer non-durables contracted 1.7% yoy in July 2016 after the modest growth of 0.9% in the previous month. The positive growth in June 2016 was a deviation from the seven months of consecutive negative growth in consumer non-durables. This is reflective of the volatility evident in the overall IIP.

Retail food price inflation moderated to 5.9% in August 2016 from 8.4% in July 2016 led by a sharp-to-moderate fall in the prices of vegetables and pulses. Food prices in the previous months (April-July 2016) had remained above 6% primarily due to high inflation in fruits, vegetables and pulses. Vegetable prices moderated to 1.0% in August from 14.0% in July 2016. Prices of pulses moderated to 22.0% in August 2016 from 27.5% in the previous month. Sugar and fruits prices, however, increased to 24.8% (July: 21.9%) and 4.5% (July: 3.5%). Services inflation showed a slight uptick to 4.2% from 4.0% in July 2016 led by higher inflation in the personal care category (August: 8.3%; July: 7.3%).

The agency believes that last week's unidirectional rally appears to have priced in benign inflation data, thus limiting scope for an incremental rally. Moreover, the spread between policy rate and overall yield curves have narrowed down sharply to 25bp-75bp from 75bp-125bp, owing to the INR1trn open market operation purchase, thus limiting scope for a sharp fall in yield. On the other hand, an uptick in global bond yields will likely keep the domestic market more submissive.

Amid global volatility in capital markets, the domestic currency has been anchored strongly on the back of a surge in investment flows in recent months and a benign current account balance. The low inflation would further solidify the fundamental state of the rupee. So, on a fundamental basis, the rupee is poised to benefit from the improved macroeconomic condition, but transitory volatility will emanate from a potential action by central banks in the developed economies.

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