Why inflation is cooling off ::Business Line

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Metal and crude oil prices are falling on weak global growth. This should keep manufacturing and fuel inflation under check.

If there was one factor that made consumers tighten their belts and investors flee from financial avenues in the last five years, it was high inflation.

The inflation rate, measured by the Wholesale Price Index (WPI), which averaged 6 per cent until 2007-08, moved into a higher trajectory of 8 per cent in the following five years. But after peaking at 9 per cent in 2011-12, inflation rates cooled off to 7 per cent last fiscal. So, are we set for lower inflation for some time to come? We could be, suggests an analysis of WPI components.

INFLATION SUBSIDES

Let’s examine the key triggers for the fall in inflation rate in the last one year. Breaking down the WPI into its components reveals that it is the decline in manufactured products inflation which has contributed the most to this fall. This is followed by fuel inflation.

Almost all commodity groups in the manufactured product category saw lower inflation in 2012-13. Basic metals, alloys and metal products, textiles and chemical and chemical products were some of the main contributors.

This reflects a fall in pricing power for producers as demand for most products, consumer and industrial, slowed this year.

In the case of fuel, the global fall in crude oil subdued prices of its derivatives — petrol, naphtha, furnace oil and kerosene. In primary products, the credit for muted price rise goes to minerals, most importantly crude petroleum. Food inflation alone defied the broad inflation trends to rise, accounting for three-fourths of inflation in primary articles (20 per cent share in the WPI) in 2012-13.

TRIGGERS FOR THE FALL

Dissecting the WPI gives us a good idea of the actual commodities which have helped subdue inflation. Crude petroleum prices (captured by WPI) rose by just 8 per cent in 2012-13, slowing sharply after the previous year’s 45 per cent surge.

The price of the Indian crude basket, which averaged $112/bbl in 2011-12, fell to $108/bbl in 2012-13. Globally, Brent crude prices have cooled on a modest growth outlook for some of the world’s largest economies, including the US and China.

In India, prices of both decontrolled and administered fuels grew at a slower rate in 2012-13 compared with the previous fiscal.

The only exception was high speed diesel. With partial diesel decontrol now in place, the earlier ad hoc sharp price hikes have been replaced with gradual monthly price increases.

On manufactured products, which make up two-thirds of the WPI, there appears to be a clear and sustainable slowdown in price rise.

In the last one year, even manufacturers of consumer products such as FMCGs and durables which have traditionally enjoyed strong pricing power, have been forced to absorb cost increases and withhold price hikes. This has muted the rate of inflation in such products.

A number of factors are believed to have contributed to the continuing rise in food prices. A shift in demand towards protein-rich foods and higher minimum support prices (MSPs) have played a big role in holding food prices aloft.

WHAT’S AHEAD

So, what is the likely outlook for inflation over two years? Inflation rates, in terms of official WPI rates at least, appear likely to remain subdued due to two factors.

One, manufactured products, which is the biggest component (65 per cent weight) in the WPI, may see lower inflation, on the global correction in industrial raw materials.

The recent downgrades to global growth outlook have seen prices of steel (billets) correcting by 50 per cent, copper by 4 per cent and aluminium by over 6 per cent in the last six months compared with a year ago period.

With consumer demand in India being rather weak, manufacturers may be keen to lower selling prices to pass on some of the savings from falling input costs, to stimulate purchases. This suggests low manufactured products inflation in the year ahead.

Two, fuel prices, which occupy an 11.5 per cent weight in inflation, may remain quite sedate over the next one year too. A weak global economic outlook has capped demand for diesel, petrol and natural gas.

According to the International Energy Agency’s latest monthly report, the outlook for global oil demand “remains subdued” and global consumption will rise by 0.9 per cent in 2013.

One sub-segment which may see higher inflation is power tariffs, which account for a 3.5 per cent weight in the WPI.

The 13 per cent rate of price rise in 2012-13 in electricity was in sharp contrast to the previous year’s two per cent rate. Tariff revisions by state discoms may peg power tariffs up.

However, the outlook for food inflation alone appears difficult to assess at this juncture. From cereals to pulses to milk, eggs, meat, fish and several other components, the unique demand-supply dynamic for each of these makes a forecast tough.

As per government estimates, overall food grain production in 2012-13 will be 1.5 per cent lower compared with last year.

But, production of pulses, which has been a key inflation driver, is estimated to be higher. If the initial predictions of a normal monsoon for 2013 come true, it will help ease the pressure on food prices.

Rising MSPs have been a matter of concern in the recent past. However, for 2013-14 kharif crop season, smaller hikes in MSPs have been recommended by the Commission for Agricultural Costs and Prices. This is but subject to cabinet approval.

With food inflation ruling high the past few years, the base effect may temper inflation rates this year.

Also, a softening trend in global agricultural commodity prices is likely to have a favourable impact.

Which rate to factor in

If an investor is looking to factor inflation into his calculations, what number should he take note of? Is it the WPI (Wholesale Price Index) or the retail CPI (Consumer Price Index)? Simply put, if you are gauging prospects for India Inc, look to WPI. And if you are keen to protect your own lifestyle, consider CPI.

But to budget for specific long-term goals, it helps to know which inflation index more closely mirrors your own spending pattern. For 2012-13, for instance, CPI inflation at 10 per cent exceeded the 7 per cent WPI inflation. The divergence between the two inflation rates was largely because of the difference in the coverage and weightage of commodities in the two indices.

Food product prices shot through the roof that year. While food articles have almost 50 per cent weight in the CPI, they have only a one-fourth share in the WPI.

The impact of food prices is, therefore, reflected more in the CPI which has been rising in recent times. The decline in WPI-based inflation is explained by easing manufacturing inflation. WPI does not capture inflation in services. CPI covers some services, including education, medical care, transport and communication.

If you are in the middle or higher income brackets, you are unlikely to be spending half or more of your disposable income on food. Therefore, CPI may be overstating inflation. You are likely to be spending quite a bit on manufactured products and services. Therefore, aggregating inflation rates in these two categories should serve as a good inflation target for your investments.

What’s in it for investors

If inflation is cooling after a long spell, what does this imply for investors?

Higher fixed income investments: More subdued inflation would mean that investors need not take big risks to earn ‘real returns’ for their two-three year investments. Locking into fixed deposits, bank deposits or fixed maturity plans from mutual funds, which now offer double digit returns, for 3-5 year periods may be a good way to reap healthy returns even as inflation recedes.

Lower physical investments: Moderating inflation may result in more modest returns from traditional inflation hedges such as gold and precious metals as investors rethink holdings.

Equities: For Corporate India, lower inflation may spell better profit margins, even if it means less room to hike selling prices of products and services. Falling prices of raw materials, ranging from palm oil to packaging material and copper, are already helping companies in sectors such as FMCG and durables report better profit growth.

A weaker commodity price outlook would thus signal a shift in investor preferences, from sectors that are major producers of materials to those which consume industrial raw materials.

While inflation does appear to be easing for now, it remains extremely difficult to forecast how it will pan out over the long term. Therefore it is best to budget for inflation rates at the ten-year average of 6 per cent when planning your long-term investments.