India Insight:CPI inflation close to two-year low

Headline CPI inflation decelerates further to 3.4% YoY in Dec: Thiscompares with 3.6% YoY registered in the previous month. This was lowerthan the market expectation of 3.5% YoY. Core inflation, on the other hand,remained largely stable at 4.9% YoY in Dec vs the previous month.

Demonetization move partly resulted in slowing inflation momentum:The cash shortage in the wake of demonetization adversely impacted thetransportation, distribution and sale of perishable items in the wholesalemarket, as these transactions are highly cash-dependent. This resulted infarmers selling perishable items (especially vegetables, etc.) at much lowerprices than required. At the same time, the slowdown in economic activity alsoresulted in reducing the demand-side pressures.

CPI inflation to remain manageable: We expect CPI inflation to average~4.5% YoY in the Mar-17 quarter (about 50bp below the RBI’s target of 5%)and average 4.6% in FY18. The temporary slowdown in economic activityexpected post demonetisation, a bumper summer crop, good progress in thesowing of winter crops (up 6.5% YoY as of the week ended 6 Jan) and activefood management by the government will likely keep inflationary pressurescontained over the next few months. However, we need to watch for upwardrevisions in MSPs (minimum support prices), a rise in rural wages (+8% YoYin Oct-16) and a rally in global crude oil prices (up 20% since Nov-16), whichcould result in upside risks to CPI inflation forecasts in FY18.

Scope of further policy easing remains: RBI has reduced the repo rate by175bp this cycle (since Jan-15). The transmission to lending rates based onMCLR has picked up, especially post demonetization, and has been to thetune of ~175–200bp across various banks. Indeed, the recent sharp surge indeposits on account of demonetisation and the consequent lack ofopportunities to deploy credit have resulted in various banks cutting ratessharply. We maintain our view that there is scope for a further 50–75bp cut inthe repo rate and, hence, banks’ lending rate over the next 12 months.

What is in the details?

CPI inflation decelerates further, largely led by lower food prices (2%YoY vs 2.6%YoY in Nov): Within the food segment, a slowdown was seenacross the board barring cereals. Indeed, vegetable prices declined further to-14.6% YoY (vs -10.4% YoY in Nov), more than offsetting the rise in cerealprices (up 5.3% YoY vs 4.8% YoY in Nov). We note that while this sharpweakness in vegetable prices is partly on account of distress selling byfarmers due to a cash crunch, a rise in MSPs is likely pushing cereal inflationhigher. Separately, fuel inflation picked up to 3.8% YoY (vs 2.8% YoY in Nov)but was more than offset by softer food and services inflation.

Core CPI inflation remained largely stable at 4.9% in Dec: However, wenote that two major energy components, mainly petrol and diesel, are part oftransport and communication, which cannot be further segregated. This limitsthe estimation of CPI core inflation based on statistical techniques other thanexclusion. That said, the pick-up seen in the transport & communicationsegment (4% YoY vs 3.8% YoY in Nov) on higher fuel prices was offset bylower personal care & effects (6.4% YoY vs 7.7% YoY in Nov).