India: What Is Driving Headline Inflation Lower?

Sharp deceleration in headline inflation

Over the last few weeks, headline inflation has moderated well below the central bank’s comfort zone. The more widely followed Wholesale Price Index (WPI) slowed to 3.2% during the week ended November 17, 2007, from the peak of 6.7% during the week ended January 27, 2007. The inflation-based Consumer Price Index (Industrial Workers) has also moderated, to 5.5% in October 2007 from the peak of 7.9% in June 2006. Three key factors driving inflation lower are: (i) a moderation in the pace of price rises for commodity products; (ii) a deceleration in food price inflation; and (iii) a delay in the price hike for domestic oil products. In addition, a higher base-effect factor has helped to contain headline inflation within the 3-4% range.

Global commodity-linked products: Inflation for the global commodity product basket, which has a weighting of 29.9% in the WPI, decelerated to 1.8% during the week ended November 17 from 7.3% during the week ended January 27. This deceleration was primarily due to the rupee’s appreciation and softening in the pace of the year-on-year rise in commodity prices.

Food products: Normal output growth for the summer crop has helped to contain food inflation over the last three months. Moreover, global food prices have also moderated over the last few months. The moderation in food price inflation is the major factor behind the softening in the Consumer Price Index inflation. For instance, inflation in the food component of Agricultural Laborers’ (AL) CPI slowed to 7.8% in October 2007 from 11.8% in February 2007.

Domestic oil prices: While international crude prices have risen 60% over the last 12 months, the government has yet to pass the price increases on to the domestic market. Indeed, as per our Oil and Gas analyst Vinay Jaising, the current weighted average realization of oil products in the domestic market implies an average crude oil price of US$60/bbl (WTI). Even if the government were to set the domestic oil product price at US$75/bbl, we believe that headline inflation would rise by about 1.7% (excluding the pass-through impact on other products).

Softening in domestic demand has also helped

Aggressive monetary tightening pursued by the central bank since 4Q06 has caused a meaningful slowdown in aggregate demand, particularly consumption growth. Corporate revenue growth for a broader basket of 1,850 companies decelerated to 11.6% during QE-September 2007 from 32% during QE-September 2006. This softening of domestic demand is reflected in WPI Inflation, excluding food and global commodity-linked products (core inflation), which has decelerated to 4.7% during the week ended November 17 from 6.7% during the week ended March 31, 2007.

Slowing consumption, strong capex improving underlying demand-supply imbalance

The RBI’s policy measures have successfully engineered a soft-landing in the growth cycle. More importantly, we believe that these measures should gradually improve the demand-supply imbalance, which was at the heart of recent overheating of the economy. While consumption spending has significantly moderated, investment growth has remained strong. The interest- rate-sensitive segments such as automobiles and consumer durables have reported an extremely weak trend over the last two quarters. However, growth in capital goods production has remained steady at high levels. Although a higher cost of capital and slowing consumption demand will result in some moderation of capex growth, we expect it to remain relatively high.

Yet policy rate cut is not likely in the near term

We do not expect a policy rate cut in the near term. First, while investment growth has picked up, a long gestation period, particularly for infrastructure, implies that effective supply (commissioning) of new capabilities will take longer. Hence, we believe that the RBI would like to keep aggregate demand growth at current moderated levels before it reverses its monetary policy stance. Second, the RBI remains concerned about higher global oil and food prices weighing on inflationary expectations. Our Oil and Gas analyst estimates that if international crude prices stay around current levels of US$88/bbl for the next 12 months and the government leaves domestic oil prices unchanged, the oil subsidy burden will rise to 1.8% of GDP in this period. The longer oil prices stay at current levels, the higher the pressure on the government to hike domestic fuel prices. Similarly, while international food price inflation has moderated recently, absolute levels remain elevated. We believe that the RBI would prefer to see a meaningful correction in international oil and food prices before officially signing off on a loosening of monetary policy. Meanwhile, market forces will ensure that banks continue to pursue a moderate reduction in lending rates. This will be inevitable, as credit growth is now lower than deposit growth, resulting in a fall in the credit-deposit ratio.

By Chetan Ahya Singapore
Morgan Stanley
December 7, 2007