By Sonal Varma & Aurodeep Nandi
Inflation dynamics in December-January recommended that the retracement of previously elevated levels of vegetable costs was the principal force behind the fall in headline inflation from more than 7% to under 5%. We think that most of the correction is completed and when vegetable costs are most likely to continue to assert marginal downward stress in the February print, it will be smaller sized in absolute terms.
Early information for February recommend that our vegetable cost tracker is -7.% month-on-month versus -25% in January, when cereal costs that idiosyncratically spiked up in January are now correcting. Other categories that have driven up meals cost inflation in the current previous, such as tea (beverages CPI) and vegetable oils, are also reduced in February. Finally, continued issues about avian flu are most likely to depress costs of meat and egg, but the big-scale culling of chickens suggests that demand-provide mismatches may well result in costs to flare up later when the overall health issues pass.
Changing dynamics of core inflation
Outside of meals cost inflation, we think core inflation dynamics are also in transition. First, the speedy pace of normalisation due to the lowered pandemic worry aspect suggests that idiosyncratic provide-side flare-ups that dominated cost dynamics in 2020 are set to lower. However, as the services side normalises, some upside inflationary surprises may well nonetheless be in the pipeline.
Second, greater petrol and diesel costs owing to increasing crude oil costs, alongside currently steep indirect taxes, imply that transportation services are most likely to stay fairly pricey. This dovetails with our third concern, i.e. greater commodity costs (crude oil, industrial metals, cotton) may well prove to be a essential upside threat as they have been outsized driver of core inflation in the previous.
Fourth, the powerful cyclical upsurge in development and firming demand suggests greater pricing energy by producers and a stronger propensity for greater input expenses to be passed onto buyers with a lag, indicators of which have been visible in January. This will also encourage importers to pass on to buyers the burden of greater customs duties and the Agriculture Infrastructure and Development Cess on some imports, which have been introduced not too long ago in the Budget. Finally, the sharp rise in telecommunication tariffs that pushed up the communications CPI via Q1-2020 is now set to build a favourable base impact in Q1-2021.
On balance, these elements recommend that when meals cost pressures may well ease in the coming months, momentum in core inflation is most likely to collect steam. We count on headline inflation to typical slightly above 5% in February and March, impacted by the unfavourable base from final year. We count on headline inflation to also typical about 5% in Q2-Q3, ahead of easing to about 4% in Q4. Overall, we count on headline CPI inflation to typical 4.7% year-on-year in 2021, down from 6.6% in 2020, due to reduced meals costs, but core CPI inflation to stay elevated at above 5% on typical, reflecting a gradual return of pricing energy. Our forecasts recommend that there is some downside threat to the Reserve Bank of India’s CPI projection of 5.2% in H1-2021, while the continued surge in oil costs may well simply erase this get.
Industrial production—normalisation ahoy
The recovery in IP development in December was largely on anticipated lines as the November information have been skewed reduced due to the various timing of Diwali in 2020, and largely stay in line with the broader theme of financial normalisation. As we elaborated in our current chart pack, a mixture of the lagged influence of simple economic situations, stronger international development, more rapidly pace of normalisation even with out a widespread vaccine rollout, greater government spending and base effects ought to trigger a powerful cyclical development uptrend in 2021. Consequently, we stay above consensus on our GDP development outlook, expecting 13.5% year-on-year in FY22 from -6.7% in FY21, greater than RBI’s projection of 10.5% and -7.5%, respectively.
RBI—inching closer to the exit
The reduced headline inflation reading amid enhancing development prospects ought to provide some comfort to RBI and justify its ‘accommodative’ policy stance and status quo on policy prices. Muted credit development suggests that the threat of greater liquidity overheating the economy remains low for now.
However, this is unlikely to stay a point of equilibrium for extended, in view of the cyclical development upsurge, indicators of increasing core momentum and fiscal activism. Rising oil costs may well also lead to a choose-up in inflation expectations in the coming quarters. Balancing medium-term dangers from the construct-up of inflationary pressures will be as crucial to monitor, and are most likely to contact for a gradual normalisation of liquidity, in our view. However, this will need cautious communications and deft policy manoeuvring as RBI also has to make certain the absorption of government borrowing with out causing yields to escalate also sharply.
In our base case, we count on RBI to preserve its policy repo price unchanged via 2021, as the output gap stays damaging (regardless of the cyclical recovery) and inflation remains inside the band of 4%+/-2% (while above the 4% target). However, as development normalises, so ought to the policy. We count on the approach of liquidity normalisation to commence in mid-2021, the policy stance to shift to ‘neutral’ from ‘accommodative’ in Q3 (July-September), a 25 bps reverse repo price hike in Q4 and 50 bps worth of repo price hikes in H1-2022, with dangers skewed towards additional hikes.
Authors are study analysts, Asia Economics, Nomura
(Excerpted from Nomura Global Markets Research dated February 13, 2021)