Inflation jumped above the RBI’s comfort zone in December 2019 and is likely to print above 7% even in January 2020. This increase has been driven by domestic supply disruptions, leading to a spike in vegetable prices (especially onions). However, its not just an onion story, with the rise being more broad based, influenced by increasing global food prices. Moreover, while demand side pressures remain weak, one-off price revisions and rising inflation expectations are starting to put pressure on core inflation (excluding food and fuel) as well. We expect inflation to moderate only gradually in FY21, with a below 4% print likely only by the second half of the year.
The RBI naturally is faced with a difficult choice with inflation remaining elevated and growth slowing down. For now, we expect the RBI to stay on hold and keep its stance unchanged (accommodative) at tomorrow’s meeting. However, going forward, we think that the scales could tip in the favour of growth as soon as inflation prints become more palatable. The RBI might look through the volatility in inflation and lay emphasis on the wide output gap, delivering a cut perhaps as soon as June 2020. Given the fact that the Union budget did not provide significant counter-cyclical stimulus to boost consumption and is unlikely to be inflationary, the case for further monetary policy accommodation has become even stronger. On liquidity, we expect the central bank to keep liquidity in surplus, in order to growth, as the monetary implications of surplus liquidity are likely to be limited on inflation for some months to come (given moderate credit growth).
Key Findings
· In the coming months, we expect headline inflation readings to remain elevated, led by a low base effect, high food prices and some rise in the miscellaneous sub-component. We expect inflation to peak to 7.5% in Jan-20. For Jan-Mar 2020, we expect average headline inflation at 7.1%.
· Over the next 6 months, we expect the headline inflation to moderate gradually (moving towards 5% by Aug-20) as food prices decline on of a correction in vegetable and cereal prices.
· While core inflation trended low in 2019 on the back of weak demand conditions, one-off factors like revision in telecom and medicine prices, rise in gold prices, second round impact from higher food prices and rising inflation expectations could lead to some rise in core inflation figures over the coming months. Our analysis shows that, in the financial year till date, a larger part of the core basket has become volatile. This suggests that any reversal in the recent trend (67% of the core basket was falling in 2019 compared to only 22% in 2018) – any idiosyncratic factors like revision in prices – could make a greater part of the core vulnerable.
· Risks: Watch out for a prolonged increase in global food prices given their strong correlation with domestic food prices. Protein inflation could remain a risk amidst any surge in milk, meat and pulses prices.
· Looking at a broader time horizon, we expect inflation to ease below 3% in Dec-20 ed by a favourable statistical base and contained food prices amidst healthy production of rabi and kharif crops. With the output gap (growth deviation from potential) unlikely to close in 2020, demand side pressures are likely to remain muted, moderating the pick-up in core inflation prints.
· We expect the RBI to keep rates on hold in Feb-20 policy meeting amidst mounting inflationary pressure. Over the next 6 months, as the inflation prints find some comfort and move down within the RBI’s target range (4%+/-2%), the RBI could act (cut rates by 25 bps) and lean towards stimulating growth. We also expect the RBI to maintain liquidity in surplus for most part of 2020.
