Base effect may pull inflation down

Wholesale price index-based inflation is set to decline in the coming months, not only on account of stringent monetary and fiscal measures by the Reserve Bank of India (RBI) and the government, respectively, but also due to a higher base effect.

Inflation is calculated by comparing the wholesale price index (WPI) of the current year for all commodities to that of the previous year, which is taken as the base year.

If the weekly WPI of the base year showed sudden upswings or downswings, the inflation rate of the current year shows a similar trend, but on the condition that the WPI for the current year is steady. This is termed the base effect.

There was an increase in the WPI from 198.8 to 199.4 for the week ended April 21 in financial year 2006-07, while the WPI for the corresponding period in 2007-08 remained constant at 210.10, thereby bringing inflation down by 32 basis points to 5.77 per cent.

An analysis of the WPI in 2006-07 reveals that right from the beginning of that fiscal, the WPI has consistently moved northward, which may substantially bring down the high level of inflation this fiscal. From sub-200 level, WPI moved to 203 in June 2006, reaching 209 by November, thereafter falling in January 2007, only to move up till the end of the previous fiscal year.

"The high level of WPI last year was basically driven by primary articles, whose index had moved sharply. This may bring down inflation level below 5.5 per cent by June this year. The inflation may continue its fall till July. In July, inflation may go up marginally, due to a relatively lower base effect. However, it will continue its downward trend thereafter," says ABN Amro Chief Economist Abheek Barua.

"If the WPI could be contained at the existing level, inflation may come down below 5.5 per cent within three to four weeks," said Punjab National Bank GM Arun Kaul.

In order to curb money supply and in turn inflation, the RBI increased cash reserve ratio from 5 per cent to 6.5 per cent since December last year. The repo rate has also been hiked from 7.25 per cent to 7.75 per cent since January 2007.

Analysts say that apart from the base effect and the impact of the RBI's monetary steps, the government's fiscal measures have also started impacting inflation. However, they do not think the RBI will immediately soften domestic interest rates.

"There could be an upswing in interest rates in the UK, Europe, Japan and China in the coming days, hence the RBI may not decrease domestic interest rates. Only in the case of the US the interest rates may soften towards the third or fourth quarter of the fiscal year; then it could have a downward impact on interest rates around the world, including in India," Kaul said.

However, analysts feel the RBI will now focus on the overvaluing rupee. "Once inflation comes to a comforting level, the RBI may slowly intervene in the currency market," Barua said.

"The RBI will now focus on the overvalued rupee. I see the RBI intervening in the market and buying dollars as rupee is overvalued by almost 13 per cent in real effective exchange rate terms," Kaul said.