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India: Return of Double-Digit Inflation This Year

India’s inflation problem has become protracted and broad-based. While a year ago inflation was primarily being driven by high food prices, risks to inflation remaining high now stem from fuel products and manufactured goods.

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India released its March inflation data on Friday, which came in at nearly 9 percent, surpassing forecasts. Core inflation (representing goods outside of food and fuel) jumped to 7.2 percent; compared to 5 percent just two months ago.

The inflation outlook is highly worrisome. First, food prices have eased a bit but the supply-demand dynamic remains tight enough that a renewed bout (weather or supply chain or global development related) cannot be ruled out.

Second, we believe that fuel subsidy pressures will rise considerably in the second quarter of the year, and by then the government will be compelled to pass on some petrol and diesel (in the 5-10 percent range) price hikes. This could readily add close to 1 percent to inflation.

Third, with wages rising by double digit, capacity utilization heading toward last cycle’s peak, manufacturing input prices rising substantially due to a broad range of commodity price increases, and interest rates still negative in real terms, there is no shortage of factors fueling demand and causing upside risk to core inflation.

On top of these risks, there is another source of inflation worry. We have gone through the detailed breakdown of the WPI (Wholesale Price Index), and find that many items in the index have not been updated for a while, some as much as six months.

Most of these items are likely to be updated on the high side, given global commodity price trends. Since the data update of these various items will likely take place at different points of time, this may result in increased volatility in the inflation outcome.

Past revision trends of WPI inflation (revised estimates have been unambiguously higher than provisional estimates) and the recent global commodity price trend leads us to believe that a majority of the unchanged indices will see an upward revision as and when they get updated. We therefore see a return to living with double-digit inflation in India this year.

Are there scenarios under which inflation could ease substantially in the near term? Unfortunately we see little respite ahead that could counter the upside risks flagged above. There might be some base effect related respite in April, but after that inflation would remain firmly above 9 percent and perhaps touch 10 percent again in the third quarter of this calendar year.

So what is the Reserve Bank of India going to do? We would cheer an aggressive, 50 basis points rate hike on May 3, or even earlier, but we are not going to make that call. The central bank remains dovish in nature, and we expect it to only go to the length of raising the possibility of sustained rate hikes for a considerable period.

The risk of the RBI continuing beyond our forecast of a terminal repo rate (the rate at which banks borrow from the central bank) of 7.5 percent has clearly risen, but we will wait for a few more data points before re-examining that call. For now, we expect 25 basis points of rate hikes in May, June, and July.

Taimur Baig is the Chief Economist for India, Indonesia and the Philippines, Global Markets Research at Deutsche Bank AG. He is a regular guest on CNBC TV.

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