Money Bol

Almost halfway into the 3rd quarter and well into the busy season, the economy is well set to make a comeback with projected growth of 6% upwards. With markets again close to the pre-crisis levels and major sectors looking up, it is only a question of time when we are able to leave the recession blues behind us. While this seems good news, market participants having become accustomed to easy monetary policy for the past year are keenly watching when the central bank reverses its stance. One of the factors driving this sentiment is inflation which has clearly been the baritone of the last two quarterly policy statements of the RBI Governor. While the base effect of last year played out for most part of this fiscal, it is projected to become a threat by March 2010.
While inflation projected to break 6% levels by March 2010 it is a question of time when the central bank is compelled to raise interest rates. However, many market participants believe that inflation is not a prime concern as it is heading towards the levels where it should be. While we would partly agree to that, we would like to look at the levels where policy makers would want to stop the prices to spiral any more. With the monthly release of data and the new series for WPI being launched shortly, it is very apparent the authorities have partly found an alternative (apart from raising interest rates) to manage inflation in the short term.
Raising interest rates in the current scenario is just not an option as the economy is still suffering from a supply driven inflation due to bad monsoon and lower production levels during the recession. Credit growth is yet to pick up to the normal levels. Hence managing inflation statistically seems to be a very smart move on the part of the policy makers. Measures like increasing the time frame of release of data would help in smoothing out effect of the numbers. Further, incorporating electronic goods would drive down the manufactured item index which is likely to constitute 80% of the WPI. While it is anyone’s guess as to when the new WPI series would come into effect, we would try to look at few ways in which the inflation might pan out in the next 4 months. While we would forecast the inflation we still believe that the WPI still continues to a flawed number with many components (around 15-18% of many components) not been for many months. We believe that the monthly release would ease out volatility and would also manage short term spikes.
Here we look at 4 likely scenarios which would help us identify the paths inflation is going to take in the remaining period of the current fiscal.

Case 1:- Assuming the index remains the same as on October 2009 for the remaining part of the year.

Case 2:- Taking monthly average growth rates for various components of WPI for the last year (Oct-08 to Oct-09) i.e. the current inflation cycle

Case 3:- Taking monthly average growth rates for various components of WPI from the last inflation cycle between Jun-07- Oct-08

Case 4:- Outlines the most likely scenario that policymakers might be able manage without much ramifications

Conclusion
From the four scenarios presented above we can see that inflation would be definitely above 6% by March 2010. While all the scenarios are closely likely, keeping in mind political ramifications we expect Case -4 to be the most likely path that would be followed in coming months. It is evident that food inflation constituting around 3.4% of the WPI is at its historic highest levels. Although the government does not have any impending threat vis-a-vis elections food inflation close to 20% (as in Case 2 following the growth rate of past 12 months) does have very serious political ramifications. Hence we can safely assume that food inflation would either not be allowed to rise very high and policy makers would cap the food prices to a certain level. With the current scenario the policy makers have effectively managed inflation and we believe the numbers can be and would be “managed” smartly, kept under control around the projected levels of around 6-7% before the central bank is comfortable in raising interest rates sometime early next fiscal.

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