Crisil Research said it did not expect any loosening of RBI’s monetary policy tomorrow due to risks of food inflation returning.
Retail inflation, as measured by the Consumer Price Index (CPI), has fallen faster than expected in the last three months, from 11.2% in November 2013 to 8.1% this February. With CPI inflation now close to the RBI’s official target of 8% for January 2015, we may have come to the end of the interest rate tightening cycle.
“Rates however, must remain on hold for now,” it said.
“There are two reasons for this stance. First, the current fall in CPI inflation is almost entirely driven by declining inflation in vegetables, with hardly any downward adjustment in core CPI inflation. While overall CPI inflation has fallen 3.1 percentage points in the last three months, core CPI inflation has fallen only 0.1 percentage points and is still lingering around 8% levels. Second, a flashback shows there were supply-side shocks in each of the last 7 years — which kept food inflation above 8% in all but one year – even though monsoons were largely normal with only one drought year.
“Thus, while the shock to vegetable prices may have abated, the possibility of another idiosyncratic shock to food prices remains high, even if monsoons this year are normal and demand-side pressures remain relatively low.”
In addition, risks of an El Nino – a weather phenomenon that could disrupt monsoons – have begun to surface, and worsening of geopolitical tensions in Ukraine could also raise global oil prices and create upward pressure on inflation of oils & fats, it added.
“With core inflation still close to 8%, any idiosyncratic shock to food prices could raise overall CPI above the RBI’s target of 8%. Given the persistent risks of a surge in food inflation in India, core CPI inflation will have to come down sharply if overall CPI inflation is to sustain below 8% and move towards the 6% mark by January 2016 – as recommended by the Urjit Patel Committee. Only when such signs emerge, can there be a room for monetary policy loosening.”
Despite an above-normal monsoon in 2013, food inflation has averaged 11.2% so far this fiscal (April-February) as a supply-related shock drove up vegetables inflation to 61.1% in November 2013 from only 5.8% in April 2013. “But 2013-14 is no outlier. Supply-related shocks have occurred in each of the last 7 years, pushing food inflation to over 8% in all years except in FY12. Moreover, the shocks appear to be random and different each year — vegetables & fruits in FY13, oils & fats in FY12, condiments & spices in FY11, pulses in FY10, cereals & pulses in FY09, and oil & fats in FY08. And high double-digit inflation has been observed in more than one food category in every year.”
Shocks have occurred even in years with good monsoons. Rainfall was above normal in 4 of these past 7 years and FY10 was the only year to have experienced a drought. So while a good monsoon is necessary, it is not a sufficient condition for lower food inflation, it said.
There has been only one persistent factor – double-digit inflation in egg, fish, meat & milk — driven by higher demand for protein-rich foods with rising rural wages. Inflation in this category is falling with declining demand pressures.
Except in FY12, food inflation has never been below 8.0% for more than 5 months in any of the last 7 years. “This shows it would be a challenge to sustain food inflation below 8% even if inflation in protein-rich foods moderates further. Any supply-related shock, not just sub-normal monsoons, could push food inflation into double-digits. Monsoon itself is at risk this year due to signs of an El Nino and needs to be watched closely.

Worsening of geopolitical tensions in Ukraine could also push oil prices higher during 2014 and create a supply-side shock for inflation in oils & fats. Higher oil prices in the past (FY12, FY13) have been seen to fuel inflation in this category. “While central banks usually do not account for such idiosyncratic shocks ex-ante, past experience shows that in India’s case, such shocks are not a low-probability event.

With core CPI inflation still lingering around 8%, any surge in food inflation will make it difficult to sustain the overall CPI inflation within the target of 8% by January 2015 even if secondround effects of the food price rise are very limited due to weak demand conditions. Monetary policy, therefore, cannot afford to be loose — at least not until core CPI inflation adjusts downwards.”

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