Policy rates are likely to remain high through the rest of 2016 if RBI maintains present CPI target, which remains too much of a close call given the present food inflation levels and the weak correlation between monsoons and food prices, says a report.
"With the present trajectory of food inflation and a technical bump to housing inflation from Pay Commission implementation, the RBI's 5 per cent target for headline CPI by March 2017 will be a close call.
"Thus, we expect central bank to stay on hold through rest of 2016 if the current policy stance is maintained under the new Governor as there are more upside risks to food inflation," said Citi India in a note today.
Their pessimism is based on the fact that core inflation is likely to stay sticky as food constitutes roughly 46 per cent of the CPI basket and the headline inflation typically is guided by core CPI inflation trends.
"We expect core CPI (excluding transportation) to stay sticky and elevated at an average 5.9 per cent in FY2017 against 5.4 per cent in FY2016," it said, adding the poor reservoir levels and rising global food prices are the biggest threat to the inflation trajectory.
The report based view on the likely impact of the pay commission awards which is likely to impart roughly 100 bps to core CPI inflation pushing it marginally above 6 per cent from current level of 5.5 per cent.
Therefore "for any rate cut hopes to reappear, prices of food items, particularly pulses and vegetables, need to correct substantially lower in the next few months, differing from the past seasonal trend, global condition worsens significantly, and finally a reassessment of real rates is needed by the newly-formed monetary policy committee."
Stating that two opposing factors of near-term hardening of prices against expectations of softening post-monsoons have divided the market, the report notes that historical trends suggest a weak correlation between monsoons and food inflation.
The report says the more important factors are government policies and global commodity trends and therefore "with the RBI's 5 per cent headline CPI target at risk, we expect RBI to stay on hold if the new Governor maintains the current policy stance".
The brokerage recently revised upwards its financial year 2016-17 CPI estimate to 5.6 from 4.9 per cent on the back of resurgence in CPI inflation, which rose to 5.8 per cent in May.
The country receives 75-80 per cent of its rainfalls during the Southwest monsoons spanning the June-September period and today the Met department has said that the rains so far have been 7 per cent below average, despite an above average projection earlier.
The report notes that the monsoons could impact food
inflation through multiple channels over different time intervals. While before the monsoons, food prices could react to early warning signals, like the Met forecast, date of arrival, etc while during the course of the monsoons, sowing, spatial and temporal distribution of rains become relevant.
In case of heavy rainfalls, the prices of certain perishable food items tends to rise as chances of wastage increase (eg. Onion/tomato shocks of 2013) and post-monsoons, the Kharif harvest and the residual level of reservoirs/ moisture content of the soil (for the next Rabi season) could play a role.
"Despite these inter-linkages, there is only a weaker direct relation between food inflation and monsoons," said the report, adding the last 20 years of data suggest a negative correlation between rainfalls and food prices is pronounced only when the monsoon deviation from normal is acute -- both higher and lower.
"In fact, the risks for food inflation are higher if there is excess rainfalls," the report said and pointed out that despite over 10 per cent shortfall in rains in 2014 and 2015, food inflation remained benign.
