RBI March rate decision - between a rock and a hard place!

RBI's March 19 monetary policy may be closer than the consensus expects ...

Most economists are expecting a 25 basis points cut in the policy repo rate to 7.50% while opinion is divided over a further cut in the cash reserve ratio (CRR).  To review, the RBI reduced the repo rate by 25 basis points to 7.75%, and also cut the CRR by 25 basis points to 4.0% in late January.  Rate cut advocates cite sluggish GDP growth (below 5% in the December quarter) and the decline in core manufacturing WPI. 

... with the continuing disconnect between the wholesale price index (WPI) and the consumer price index (CPI).

India's February CPI (yoy basis) climbed further to 10.9% from 10.8% in January 2013, the highest reading for CPI inflation over its short history.  By comparison, February WPI was 6.8%, the second lowest reading in more than three years (January 2013 at 6.6% was the lowest). The divergence can only partly be explained by the higher weighting of food and food products in the CPI (46%) versus the WPI (24%). Food inflation has been running higher than headline inflation for both the indexes - CPI food inflation was 13.4% in January while WPI food inflation was 10.2%. Indian policy makers and analysts (present company included) have historically focused on the WPI (in contrast to the CPI focus for most other economies) because of its timeliness and breadth; the new comprehensive CPI (rural and urban) with monthly readings was introduced only in January 2011.

Especially as the core inflation measures for the two indexes also diverge significantly.  

The decline in WPI inflation is driven by the moderation in core manufactured products (excluding foods) inflation - core manufactured products inflation declined to 3.8% in February 2013 (the lowest reading in almost three years) from a near-term peak of 8.4% in November 2011. Even seasonally adjusted trends for core manufacturing WPI suggest that inflation pressures are contained.

By comparison, core CPI inflation (excluding food and fuel) remained elevated at 8.4%, having troughed at 8.0% in September 2012. Cutting the repo rate (which is already slightly negative based on the core CPI) given the elevated and sticky CPI inflation would be hard to justify given RBI's stated focus on containing inflation as well as supporting growth.

Above average growth, low inflation - I like the "new normal"!

Economic forecasts generally go with the usual caveats, but the IMF's global economic forecasts suggest a reasonably healthy global economy in the coming five years compared to the economic environment since 1980.

Per its October 2012 World Economic Outlook (updated in Jan 2013), the IMF expects global GDP growth of 3.5% in 2013, just above the average of 3.4% from 1980-2008 (the great recession of 2009 saw a decline of 0.6% in global GDP). The outlook for the following years is stronger with growth of 4% or higher.
Meanwhile, global consumer price inflation is expected to be well contained, remaining below 4%; similar to the levels in 2002 to 2006.  Global consumer price inflation averaged 13% from 1980-2008. 
Expected global growth is slightly below the rates seen in the 2003 to 2007 period, but still seems quite impressive if we look at a longer time period.  Maybe the new normal ain't so bad after all!

Rupee seems fairly valued on a real basis

The Indian Rupee now seems fairly valued on a real effective exchange rate basis.

As such, portfolio flows would be key to the Rupee's direction from current levels with significant downside limited barring significant portfolio outflows.

Note: 

a) A caveat to this analysis is that the BIS uses the wholesale price index (WPI) for India versus consumer price index (CPI) for other countries; as noted earlier by AASSB analysis [refer 14 Feb blog] India's CPI and WPI are quite disconnected at the moment.  As such, India's REER may be understated by using the WPI instead of the CPI.

b) Nominal EERs (NEERs) are calculated as geometric weighted averages of bilateral exchange rates. Real EERs (REERs) are the same weighted averages of bilateral exchange rates adjusted by relative consumer prices. 

India's inflation dis-connect

India's January CPI (Consumer Price Index) and WPI (Wholesale Price Index) readings highlight the growing dis-connect between the two inflation measures, and would further complicate monetary policy decision making by the RBI.  This warrants caution on Indian equity markets - expectations of economy boosting lower policy rates (driven by lower inflation) have driven significant foreign investor inflows year to date ($7.8 billion).

Indian policy makers and analysts (present company included) have historically focused on the WPI (in contrast to the CPI focus for most other economies) because of its timeliness and breadth; the new comprehensive CPI (rural and urban) with monthly readings was introduced only in January 2011.

India's January CPI (yoy basis) accelerated to 10.8% from 10.6% in December 2012, and significantly higher than the 7.5% in January 2011.  January 2012 marked the highest reading for CPI inflation over its short history.  By comparison, the January WPI declined to 6.6% (below consensus expectations of 7.0%), from 7.2% a year earlier as well as in December 2012. This was its lowest reading since November 2009.

The divergence is partially explained by a) the higher weighting of food & food products in the CPI (49.7%) versus the WPI (24.3%) as food inflation is higher than headline inflation for both indexes, and b) higher measured food inflation in the CPI versus the WPI (CPI food inflation was 13.2% in January versus only 10.6% for the WPI).

Even the core inflation measures for the two indexes diverge significantly, thought lesser than the headline prints.  The decline in WPI inflation is driven by the moderation in core manufactured products (excluding foods) inflation - core manufactured products inflation declined to 4.1% in January 2013 from a near-term peak of 8.4% in November 2011. Core CPI inflation (excluding food and fuel) remained elevated at 8.4%, having troughed at 8.0% in September 2012.