WPI Inflation Declining food inflation and rising cost pressures::Ambit

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WPI Inflation

Declining food inflation and rising cost pressures

Inflation in April 2011 fell to 8.7% YoY from 9.4% in March 2011 on account of a decline in food inflation. The fall is attributed to the decrease in manufactured items (from 7% to 6.2%), crude oil (from 6.3% to 1.9%), minerals (from 12.2% to 7.4%), non-food articles (primarily fibers) and fruits. While there has been marginal decrease in manufactured product inflation to 6.2% YoY in April, the broader assessment indicates intensifying margin pressure and low pass-through coefficient. While the risk of further escalation of costs persists, we believe further monetary tightening could hamper the growth outlook.

m      Primary food inflation falls to 8.7% YoY, while overall food inflation rises 7.6%: The decline in primary food inflation to 8.7% in April 2011 (from 9.5% in March) was on the back of a 0.4% MoM decline in the high-protein components index – eggs, meat & fish (EM&F), 1.7% MoM decline in condiment & spices, which followed a 7.5% MoM fall in March 2011. Tea prices have fallen 5.4% MoM in April 2011.  Overall, there has been a declining trend in EM&F index, while milk prices rose by 0.9% MoM in April 2011. During summer, declining supply is the driving force in determining milk prices whereas slower demand is the driving force in determining EM&F prices. However, the fruits & vegetable index rose by 10.3% MoM (vegetable 2.2% and fruits 15.7%), followed by other food articles index by 2.4% MoM. Inclusive of the 0.5% MoM rise in manufactured food index the overall food inflation rose marginally to 7.6% YoY in April 2011 (from 6.8% YoY in March 2011).

m      Increase in primary raw material cost: For the month of April, the non-food primary articles rose by 1.8% MoM on the back of a steep 7.2% MoM rise in raw rubber and broad-based increase in prices of items like oil seeds (1.4% MoM).  Raw rubber index has been rising consistently since September 2010 by nearly 44 %. Other non-food article index rose by 3.6% MoM in April on the   back of a rise in prices of several products: sugarcane 7.2%, logs and timber 4.6%, gaurseed 3.8%. However, the prices of gingelly seed declined 18% MoM and fodder dipped 2.7%. 

m      Fuel cost is still a risk: Following the 8% hike in petrol prices by Rs5/lit on 15^th May 2011, there is a strong possibility of price hikes for diesel, LPG and kerosene given the ballooning under-recoveries of oil PSUs. Assuming 10% hike in diesel price, the cumulative impact of hikes in petrol and diesel prices will translate into 60bps increase in YoY inflation, implying a rebound in inflation to over 9%. Hence, critical risk on the cost side can potentially originate from the sustained firmness on global crude prices, with crude Brent prices hovering around US$113/bbl.    

m      Pass through coefficient didn’t change despite a fall in material cost (primary ex- food): The manufactured product inflation decreased to 6.2% YoY in April 2011 (vs 7% a month back). The decrease in the cost of raw materials dipped to 20% YoY in April 11 from 21% a month back for primary ex-food. However, fuel prices rose by 13.3% YoY in April11. The pass through coefficient (12 average elasticity of manufactured product inflation-ex food, gold and silver w.r.t. primary-non food inflation) remains the same. The pass through coefficient remains at 0.08% for the month of April 11.

m      Only few sectors have demonstrated rise in pricing power: Overall, except for edible oils, we see slower and proportionately lower response of product prices to the rise in input cost. This is particularly evident in the case of automotives and cotton textiles. Declining pass-through for automobile industries (1.8% YoY inflation) is surprising and possibly reflects intense competitive pressure. At 24.7%YoY cotton textile inflation is much smaller compared to the 101.2% YoY spike in raw cotton prices and is symptomatic of severe margin pressure.

m      RBI may tighten interest rate by 25bps to rein in inflation to desired level: The 50bp hike in policy rates in April 2011 was justified by RBI as an appropriate response to strengthening pricing power in the manufacturing sector.  However, our pass-through estimation does not substantiate the same. While the recent correction in commodity prices is reassuring, the potential for moderation in inflation in the near term will be constrained by escalation in fuel prices and its spill over impact on the broader economy.  While we believe that inflation numbers can potentially bounce back to 9% level in the coming months in line with RBI’s guidance till September 2011, overstatement of pricing power by the central bank and aggressive rate hikes can hurt growth significantly. However, given RBI’s hawkish stance there is still a possibility of another 25bps hike.