The monthly inflation number for the month of November 2016 came in at a 2-year low of 3.63%. This number was keenly watched after the demonetization exercise which commenced on November 09th 2016. There was an expected slowdown in inflation, especially in food inflation due to contraction in demand. While good monsoon and a bumper Kharif crop have been instrumental in bringing the inflation down, the sharp fall in inflation in November 2016 was also driven by weakening demand. The liquidity crunch created by the demonetization exercise was in a way responsible for the sharp decline in inflation during November.
Breaking up the inflation number for November 2016…
For the month of November 2016, CPI inflation came in at 3.63%. This compares very favourably with 4.20% inflation in the previous month as well as the 5.41% inflation announced in November 2015. The real driver for lower inflation was food inflation. For the month of November 2016, food inflation came in at just 2.11% as compared to 3.32% in the month of October 2016. Food inflation also compares very favourably vis-à-vis the November 2015 food inflation number of 6.07%. Both in terms of food inflation and overall CPI inflation, there has been a sharp fall in the rural and the urban areas, although the fall in urban areas has been more pronounced.
The one challenge for the government to address will be that non-food inflation has continued to be sticky. As the above chart indicates, the food inflation has moved below the overall inflation since the last 3 months ever since the monsoon data and Kharif data started trickling in. But it also means that non-food inflation has hardly moved; in fact it has only worsened in the last few months. This comparison becomes relevant as Brent crude prices have already moved up from $46/bbl to $54/bbl in the 2 weeks since November 30th. As far as CPI inflation is concerned, oil prices have a multiplier effect and that is something one needs to be cautious about when looking at inflation.
Key triggers for lower CPI inflation…
Among the key components of food inflation, cereals and milk products have continued to remain around the average CPI inflation. That is a sharp fall from the highs that we saw in the pre-monsoon period. Pulses, which saw prices shooting through the roof a few months ago, have come back to normal territory with November pulses inflation flat at 0.23%. In fact vegetables inflation has been negative and that has largely helped food inflation stay at the level of 2.11%. If the RBI December policy announcement is anything to go by, they do see distinct upside risks to oil prices emanating from the base effect and higher crude oil prices. That was one of the reasons for the status quo on repo rates. Normally, the base effect tends to wane around December and that leads to a spike in inflation from the New Year. Also, the oil prices need to be closely monitored. With India’s 80% dependence on imported oil, there is the big risk of imported inflation. A strong dollar will also import inflation and that too needs to be factored in.
How will CPI inflation give direction to RBI rates trajectory?
At the current juncture, we are not sure if the RBI would give too much weightage to the low levels of food inflation and overall CPI inflation. The RBI would be comfortable with its dovish rates trajectory as long as the average inflation stays under the 5% mark. That is something that will have to be watched since oil prices have started moving up and the base effect will start waning from December onwards. The RBI, probably, realizes that monetary policy has done its bit and the need of the hour may be a little more of fiscal policy focus. This may come in the forthcoming Union Budget in terms of a more friendly tax structure or in the form of greater public expenditure. The RBI may choose to observe the CPI and the WPI data for a little longer before taking a call on rates. While we do believe that the rates are headed down over the next couple of years, the RBI may want to juxtapose the CPI and WPI data for a few more months.
Don’t forget the impact of demonetization…
While there is still no conclusive data on the impact of demonetization on inflation, the correlation is hard to miss. Retail outlets in rural and semi urban areas as well as consumer-facing outlets have seen a sharp reduction in footfalls. That will mean lower demand and obviously lower inflation. This will be the reverse of the demand-pull inflation that we have seen in the past. That is where the RBI will be keen to combine CPI, WPI and IIP data and take a holistic view. The next RBI policy in February may be a lot more conclusive in its view as the impact of demonetization will be a lot clearer by then.