Can a fall in Nov'12 WPI inflation, induce RBI to cut rates?
Dec 15, 2012

Author: PersonalFN Content & Research Team

Contrary to the expectations, Inflation for the month of November 2012 dropped to 7.24% from 7.45% recorded in the month of October 2012. Thus if we observe, after some intermediate upticks, there seemed to be moderations in WPI inflation.

WPI Inflation eases
WPI inflation November 2012

(Source: Office of the Economic Advisor, PersonalFN Research)

The unexpected drop in WPI inflation can mainly be attributed to softening of prices in manufactured goods and dip in the fuel and power cost, which have a weightage of 64.97% and 14.91% respectively in the WPI index. However, rising cost of food articles had a cascading effect to moderation in prices seen in manufactured goods and easing fuel and power cost. Hence, as a result the drop in WPI inflation for November 2012, as against the previous month was just 21 basis points, thereby yet keeping WPI inflation over the comfort zone of RBI.

Fuel & Power inflation:

Following the global trend of falling crude oil prices, the retailing price of petrol was reduced by about 95 paise mid-November. The prices have been slashed for the second time in last 2 months. All major constituents of the index of fuel and power such as bitumen and furnace oil, naphtha, light diesel oil and aviation turbine fuel saw a declining price trend; LPG has been an exception though. As a result Index of fuel and power slumped by 0.6% in November 2012 (on Month-on Month basis).

Food inflation:

Food price inflation remained stubbornly high in November. The index for food articles increased a little under one third of a per cent on month on month basis. Snapping a trend of price moderation (on month on month basis) in food articles observed over last couple of months; this therefore exacerbated the monthly price pressures.

So, would RBI go in for a rate cut in the upcoming monetary policy review?

Although the WPI inflation has been lower than expected, the RBI may not be induced to cut rates in the 3rd quarter mid-review of monetary 2012-13 (scheduled on December 18, 2012), as the WPI inflation still remains over the central banks comfort zone. In order to manage the liquidity situation into the system the RBI has thus far resorted to Cash Reserve Ratio cuts and OMOs. Going forward too, in order to manage liquidity situation in the intermediate, diminutive CRR cut (of about 25 bps) along with bond buying can be resorted to by the central bank. The daily borrowing by banks under Liquidity Adjustment Facility (LAF) window has averaged about 1,00,000 crore in November which is very high and is out of the comfort zone of RBI as it expects daily LAF borrowing to remain around Rs 60,000 crore. Moreover, a bounce back in Index of Industrial Production (IIP) data for the month of October 2012 (to 8.2%), could be an excuse to keep rates policy unchanged in the aforesaid mid quarter review. In the first quarter of the new calendar year however; we could see policy rates being cut gradually taking into account growth-inflation dynamic, liquidity condition and external developments.

Policy rate tracker

	Increase / (Decrease) in FY12-13	At present
Repo Rate	(50 bps)	8.00%
Reverse Repo Rate	(50 bps)	7.00%
Cash Reserve Ratio	(50 bps)	4.25%
Statutory Liquidity Ratio	(100 bps)	23.00%
Bank Rate	(50 bps)	9.00%

(Source: RBI website, PersonalFN Research)

Our View on inflation:

Although the trend of a moderation in WPI inflation may continue due to softer crude oil prices at present and other commodity prices remain lower; the weakening of the Indian rupee may seep in stickiness in WPI inflation. The ride may not be as smooth given the increasing geo-political tensions in Middle East, as this could push crude oil prices higher. Furthermore in coming months, fiscal management of the Government would be closely monitored and if Government overshoots the limit of borrowing it has had set for FY 13, then rupee may again take a beating. Food article inflation may not go down as expected if supply constraints are not corrected. Thus for about a couple of months, we see WPI inflation plateauing around the 7.00% plus mark.

What should equity investors do?

In our view, the Q3FY13 GDP growth rate of 5.3% reveals that the slump in the economic growth rate has been rather protracted and confirms the slowdown for the Indian economy. Yes, indeed the Government has announced enough reform measures which can put the country on growth path. But what looks to be close watched is how these reform measures take shape with approval awaited in the winter session of the Parliament. The Government has won votes in favour of multi-brand retail in both the houses of the Parliament (Lok Sabha as well as Rajya Sabha), which can propel India’s robust consumption story and add to growth. However, it noteworthy that for inclusive growth, the financial sector reforms are needed which is still to be discussed in the winter session of the Parliament; where the opposition could have their reservation on certain critical issues, and even the Government alliance partners could try to extract their pound of flesh. For instance, the Government’s single largest opposition - the Bhartiya Janata Party (BJP), is not in favour of increasing the FDI cap in financial sectors beyond 26%. Likewise they (the BJP) are reluctant to back any provision that is not in line with the Parliamentary panel's recommendations, and could have certain reservation about some provisions of the banking laws amendment bill. Thus reckoning these risk facets on the Government’s reform agenda, Fitch (an international rating agency) has said that while recent reform proposals by the Government are potentially supportive of growth, the country may need time to work in uplifting economic growth rate and face political risks in their implementation. “Policy slippage and / or mounting evidence of a structural decline in the trend growth rate, such as protracted relatively weak economic data, could cause the ratings to be downgraded,” its report said. It is also said by the rating agency that, India’s sovereign rating could be cut if the Government loosens fiscal policy in the run-up to elections due by 2014 or sees a prolonged slowdown in economic growth.

Thus we are of the view that, the winter session of the parliament would be very crucial this year, because there are several important bills which are awaiting clearance such as the Pension Bill, Insurance Bill, Banking Laws Amendment Bill, Real Estate (regulation & development) Bill – which can put India on the growth path. For instance, if the pension and insurance bill goes through it would aid development of the capital markets to a great extent and will provide access to capital. But it seems that various opposition parties could flag their own ideologies onto many of these bills, and there could be disruption in the Parliament, which may lead the markets to consolidate for some time. Also while populist measures are also expected from the Government ahead of 2014 election, its impact on the fiscal deficit target also needs to be monitored carefully.

Speaking about the global economy, in the U.S. while the economy has shown an up-tick in the Q3 GDP number, supported by elevated consumer confidence, the fiscal cliff faced by the U.S. remains a source of concern; which if not handled well could pull the U.S. economy into a recession. In the month of December 2012, negotiations with the Republicans over the looming fiscal cliff will dominate the news flows from the U.S. The Federal Reserve may extend its monetary stimulus (commonly known as Quantitative Easing) to the New Year, but they are cognisant about the fact that this (the fiscal cliff) may pull the country into a recession, if the taxes aren’t increased. In the Euro zone although tense nerves of debt crisis have calmed down with European Union (EU) and the International Monetary Fund (IMF) have agreed to unblock Greek bailout with a package of measures worth €40 billion (aimed at bringing an immediate 20% reduction to the country's debt) and loan restructuring being approved (by European Commission) for Spanish bank loans (which is expected to inject around €37 billion into the Euro zone); it would not be too long before fresh crisis in Europe could flare up. Apparently, the stronger Euro zone nations are facing the risk of downgrades. Last month, Moody’s stripped France’s credit rating to “AA1” from “AAA” and declared that the outlook remains negative. Germany too has seen a descending trend in the GDP growth rate for the last three quarters; which again indicates that even the stronger nations in the Euro zone are now reeling under pressure, and if we assess, the entire Euro zone it remains mired in a recession. While the European Commercial Bank (ECB) may think of cutting rates (from a record low of 0.75%), in order to revive economic growth rate in the Euro zone, this easy monetary policy would do more harm than good to the Euro zone economies in the long-term.

Thus in the backdrop of the global economic and political environment we flag concerns of risk inducement, and therefore recommend investors to stagger their investments to mitigate risk. While in investing in equity mutual funds, we recommend one to opt for the SIP (Systematic Investment Plan) mode of investing, as it will enable you to mitigate the volatility through rupee-cost averaging and power your portfolio with the benefit of compounding. However, while selecting mutual funds for your portfolio, prefer the diversified equity funds which follow strong investment processes and systems, and invest with a long-term horizon of at least 5 years

What should debt investors do?

Looking at the growth-inflation dynamics, interest rates are likely to hover around the present elevated levels at least until first quarter of the new calendar and till the central bank feels WPI inflation is moderating.

Hence at present while taking exposure to debt mutual funds and fixed income instruments, one should clearly know their investment time horizon. Investors with an extreme short-term time horizon (of less than 3 months) would be better-off investing in liquid funds for the next 1 month, or liquid plus funds for next 3 to 6 months horizon. However, investors with a short to medium term investment horizon (of 1 to 2 years) may allocate a part of their investments to short-term income funds which should be held strictly with at least 1 year time horizon.

The present scenario also seems comfortable to look at longer horizon debt mutual funds. Thus, if you have a longer time horizon, then you can now hold some exposure to pure income funds. Since longer tenor papers could become attractive, longer duration funds (preferably through dynamic bond / flexi-debt funds) can be considered, if one has an investment horizon of say 2 to 3 years. However, one may witness some volatility in the near term as there is always an interest rate risk associated with longer maturity instruments.

Fixed Maturity Plans (FMPs) of upto 1 year may for some more time yield appealing returns and can also be considered as an option to bank FDs only if you are willing to hold it till maturity. You can consider investing your money in Fixed Deposits (FDs) as well, before the interest rates offered on them are reduced further. At present 1 year FDs are offering interest in the range of 7.50% - 9.00% p.a.

What should investors in gold do?

Going forward, the risk-event period is supportive for gold. In India stiff WPI inflation level (over the comfort zone of the RBI) would preserve gold’s status as a hedge against inflation and a store of value. Likewise if the Government loses focus on fiscal consolidation ahead of 2014 general election, it could encourage smart investors to take refuge under the precious yellow metal. Also for the U.S., their fiscal situation would fraught the risk and may have a rippling and crippling effect. And if the Federal Reserve extends its monetary stimulus (commonly known as Quantitative Easing) to the New Year, amid the worries of fiscal cliff that could be positive for gold. Also, if ECB cuts rates (from a record low of 0.75%), in order to revive economic growth rate in the Euro zone; that again would aid gold. The demand for gold is like to remain robust ahead of festive and wedding season. It is noteworthy that, in India, traditionally the demand for gold rises in the last quarter of the calendar year.

So, given the above backdrop where long-term economic problems still persist – especially in the developed economies, we think the ascending move for gold is intact. Also the ascending move would be well supported if festive and wedding season demand indeed picks up. Hence in this context GETFs would continue to do well, due to positive impact on gold prices.

At PersonalFN, we recommend that you should have a minimum of 5%-10% allocation to gold. Invest in gold with a long term perspective with a time horizon of 10 to 20 years.