The composition of the Indian cricket team and the on-field tactics of the team captain are a subject on which most Indians have strong opinions regardless of whether or not they have played professional cricket. Similarly, the RBI's monetary policy - particularly its interest rate policy - is a subject on which a variety of Indian businessmen, politicians, fund managers and stockbrokers have strong opinions regardless of their macroeconomic expertise. However, whilst our strong but ill-informed views on cricket might not have damaging implications for the nation, the ill-informed debate which takes place on monetary policy does have adverse implications for the country.
At present the consensus view seems to be that rate cuts from the RBI are becoming increasingly likely in FY15. However, if you probe the businessmen and the politicians who are shaping this consensus view about why a rate cut is justified, they have little else to say beyond pointing to the 25% drop in the price of crude since June 2014 and pointing to the cooling in food inflation. As I explain below, neither is a strong enough argument to justify rate cuts.
The easiest way to understand CPI inflation is to break it into three categories: food (which is around 50% of inflation), fuel (which is around 10%) and "core" inflation (which is the remaining 40%).
Has food inflation (which accounts for 50 % of CPI) been tamed structurally? No, not yet.
Several economists have highlighted that the drivers of food inflation over the past decade are linked, in part, to policy decisions taken by the UPA around: (a) heavy buying of cereals by the Food Corporation of India; (b) a 100%+ increase in the Minimum Support Prices of cereals; and (c) a reluctance to disturb the Agriculture Produce Marketing Committee (APMC) construct which empowers middlemen and kills the price signals to the farmer. Whilst the NDA is saying the right things about reforming these perverse drivers of food inflation, it is premature to say that the NDA will carry out the necessary reforms to slay the food inflation dragon. Disturbing the APMC construct, for example, will have the economic interests of middlemen who have been for a long time loyal supporters of the BJP. It is not obvious to me that the BJP has the political desire to alienate such loyal and well heeled supporters.
Does the sharp fall in crude prices imply rate cuts? No.
Falling crude prices will affect the 'Fuel & Light' component of inflation to some extent but will have minimal impact on the overall retail inflation, as 'Fuel & Light' has only a 9.5% weight in the CPI basket. It is worth noting that whilst 'Fuel & Light' inflation has been moderating over the past two years (down 6.9 percentage points), the overall CPI showed signs of moderation only last month (in the wake of food inflation moderating). Moreover, as the RBI itself said in its 30 September policy, it will choose to wait and watch where global commodity prices are headed before taking rate action on the back on falling crude prices. The RBI believes - and has said to repeatedly - that geo-political risks around crude prices are still high.
Has core inflation been tamed structurally?
No, not yet.
Core inflation has moderated by 1.8 percentage points in the past two months, as the RBI's rate hikes of 75bps in 2HFY14 hit home. However, if you look at corporate profit margins (which have held up nicely) suggests that it is premature to say that core inflation (which accounts for 41% of CPI inflation) has been tamed structurally. Simply put, if Indian businessmen do not take a hit on their profit margins, it is not at all obvious that core inflation can come down in the absence of food and fuel inflation coming down.
In summary, as I see it, the central challenges around India's inflation problem - structurally high food inflation and stubbornly high core inflation - remain unresolved although the NDA Government is making the right noises about tackling some of these issues. Furthermore, the RBI is unlikely to get carried away by the crude price decline and use this to justify rate cuts. With inflation likely to rise in 4QFY15, a more likely sequence of events is that the RBI will watch crude prices and the NDA's reform programme carefully in FY15 before acting in FY16.
Saurabh Mukherjea is CEO of Institutional Equities at Ambit Capital. The views expressed here are personal.
This column appeared in the December 2014 issue of Wealth Insight.
This article was originally published on December 22, 2014.
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