October WPI Inflation: Gradual moderation underway. Kotak Sec

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Economy
Inflation
October WPI Inflation: Gradual moderation underway. Headline WPI moderated
marginally from 8.62% in September to 8.58% in October, the lowest since January
2009. However, the index actually rose by 0.4% over the previous month, led by all the
three sub-indices. Manufactured products inflation firmed to 4.75% while fuel inflation
came in at 11% and primary articles at 16.7%. The August inflation rate was revised
upwards to 8.82% from the provisional reading of 8.51%.




Food inflation eases on base effect, but structural factors to limit extent of moderation
Food inflation, defined as the weighted average of primary food articles and manufactured food
products, came down to the single-digit zone for the first time since May 2009 at 9.97% from
10.82% in September. The moderation in food inflation was led by primary food articles, where
the inflation eased to 14.13% from 15.71%. However, this was solely due to a positive base
effect, as the primary food articles index rose by 0.6% m/m in October 2010 as against a strong
2% m/m a year ago. Manufactured food products inflation rose to 3.02% from 2.8% in
September, on the back of price pressures in edible oils, oil cakes and ‘tea and coffee processing’
sub-components. The recent moderation in food inflation is likely to continue, especially as a very
strong base effect is seen in November and then in January. Nonetheless, concerns on food
inflation remain as (1) structural factors on the food side will limit the extent of moderation in food
inflation. Prices of protein-rich food items such as milk, ‘eggs, meat & fish’ have been running in
excess of 20% for over a year now as the supply response has been weak to the higher
consumption of these food items. (2) Global food prices have also firmed up sharply and could spill
over to the domestic prices. This is especially true for prices of pulses, edible oils, etc., where India
is a net importer. (3) Higher MSP prices would act as a natural floor for food-grain prices.

Non-food manufacturing inflation picks up
Non-food manufacturing inflation, which is indicative of demand side price pressures, edged up
marginally in October to 5.1% from 4.96% in September. The index also rose by 0.28% m/m as
opposed to a flat reading last month, as all sub components other than ‘Wood & wood products’,
‘Rubber & rubber products’ and ‘Transport and equipment’ index rose. With QE 2 by the Fed in
place, the surfeit of global liquidity is likely to see commodity prices remaining firm. This would
have implications also for the mineral oils index as also the crude oil item in primary articles index.

Upside risks to RBI’s year-end WPI projection increases chances for another rate hike
In the last policy meeting, RBI had hiked both the repo and reverse repo rate by 25 bps each to
6.25% and 5.25%, respectively, citing inflation concerns. The central bank had maintained its
inflation projection at 5.5% for end-FY11E (6.0% as per the 1993-94 series). We, however, see
upside risks to RBI’s end-FY2011E inflation projection as (1) due to factors mentioned earlier, food
prices have not softened to the extent expected by the RBI when it made its projections in July. (2)
Global commodity prices have also reversed their softening trend and have firmed up significantly
in reaction to the Fed’s QE 2 program. (3) The base effect under the new WPI series is less than
that in the series with the old base. We expect inflation to moderate only gradually to around 7%
by December and to around 6.5% by end-FY2011E, assuming that a likely fuel price increase will
reduce the under-recoveries. The RBI had, in its monetary policy statement on November 2
signaled a pause in the policy interest rates for now. Thus, there is unlikely to be any policy action
in next monetary policy meeting on December 16. However, we factor in another 25 bps increase
in both the Reverse Repo and the Repo Rate by end-FY2011E, possibly on January 25. Thus, so far
as monetary policy stance is concerned, RBI would continue to be bothered by the high and sticky
inflation levels rather than the lower-than-expected IIP numbers released on Friday last.