Are markets prepared for higher inflation?

Analysts expect inflation to peak in H1FY17 and moderate thereafter on the back of positive impact of monsoons

Though the Reserve Bank of India (RBI) in its review of the Monetary Policy has kept key rates unchanged, the focus has yet again shifted to the possibility of higher inflation going ahead.

While reviewing the monetary policy, the central bank said that the inflation surprise in April reading makes the future trajectory of inflation somewhat more uncertain. It, however, stuck to its earlier forecast of meeting inflation targets of 5% by March 2017.

Firming international commodity prices, particularly of crude oil; the implementation of the 7th Central Pay Commission awards which will have to be factored into projections as soon as clarity on implementation emerges; the upturn in inflation expectations of households and of corporates; and the stickiness in inflation excluding food and fuel are some of the reasons that the central bank has cited while remaining watchful on the inflation trajectory.

 

Analysts, too, expect inflation to peak in the first half of 2016-17 (H1FY17) and moderate thereafter on the back of positive impact of monsoons.

"We expect the next few prints to remain elevated (expect 5.9% in May) on high food inflation. While monsoon forecasts have been encouraging and inflation will likely slow in H2-FY17. We expect inflation of 5.3% in FY17 (ending March 2017), versus 4.9% in FY16," said Chidu Narayanan, Economist for Asia at Standard Chartered Bank in a recent co-authored report with Betty Rui Wang and Shuang Ding.

So, how are markets reading into the developments? Are they pencilling in the possibility of higher inflation? What if the actual monsoon is lower-than-projected, or the estimates are revised downwards?

Andrew Holland, CEO of Ambit Investment Advisors suggests that the road ahead for the economy including inflation trajectory, fiscal deficit and even the future rate cuts by the central bank depend to a large extent on how the monsoons pan out.

"In case the monsoon turns out the way everyone is hoping it will be, then the RBI will have an opportunity to do more in terms of rates. There are expectations that inflation could tick a little higher going ahead as the economy picks up. Monsoon is key. In case we do have good rains, food prices are likely to head lower, which in turn can keep a lid on food-price led inflation," he says.

At the current levels, analysts say that the markets are factoring in the possibility of higher inflation going ahead, and this is evident from the fact that the markets have inched up higher despite the rise in oil prices globally, and the higher CPI (consumer price inflation) print in April. They, however, caution that any disappointment in case of how the monsoon turns out eventually could send inflation soaring and the see markets correct sharply.

G. Chokkalingam, founder & managing director, Equinomics Research & Advisory, explains: "Going ahead, we will not be able to enjoy negative wholesale price inflation (WPI). The CPI trajectory will depend on monsoon. I think the markets are factoring in the possibility of higher inflation. In case the monsoon disappoints, we can see spiralling inflation and in that case, the markets can easily correct 10% - 15%."