Sticky inflation for September, to preclude a rate cut by RBI
Oct 15, 2012

Author: PersonalFN Content & Research Team

After easing from the earlier 9.00% plus mark - maintained by the inflation bug for good 12 months (i.e. from December 2010 until November 2011), the inflation bug now seems have discovered a new sticky region, by plateauing around the 7.00% plus mark for the last nine months.

The headline inflation as measured by the Wholesale Price Index (WPI), for September 2012 stood at 7.81% and even the earlier provisional data (of 6.89%) for July 2012 was revised upwards to 7.52% (See chart below).

Inflation spikes up again
WPI inflation - Sept 2012

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

The uptick in the headline inflation can be attributed to the following components, which form a part of the WPI:

Fuel & Power inflation: With the Government increasing fuel prices, in order to compensate the under-recoveries of the oil marketing companies, a detrimental impact was seen fuel and power inflation, as it rose significantly (by 357 basis points) to 11.88% from 8.32% in August 2012.

Going forward, too we could see upward pressure on the fuel inflation given the fact that the Government has raised the prices of diesel by Rs 5 per litre and non-subsidised LPG has become dearer.

Moreover, the Brent crude oil prices too seem to rising once again (currently at U.S. $116.65), after stimulus measures being adopted by the central bankers in the developed economy, to provide an impetus to economic growth. Also the geopolitical tension between Turkey and Spain are refraining oil prices to mellow down. Thus although the International Energy Agency (IEA), has reduced its demand growth forecast for next year (due to worsening global economic growth), it may not lead to oil prices cooling; in fact we may see an upward bias. However, the adverse effect of high fuel price for India on its current account deficit could be negated to a certain extent if the Indian rupee continues to appreciate against the U.S. dollar, after a slew of reform measures adopted by the Government.

Food inflation: Food inflation (which has a weightage of 14.34% in the WPI), for the month of September 2012 reduced to 7.86% from 9.14% in August 2012, seemingly because of the positive impact of a good monsoon which led to a decent agricultural produce.

But going forward, the increase in diesel prices along with a trickling effect of high freight charges are likely to put pressure on food inflation as well. This is because diesel is an essential transport and industrial fuel, and the rise in the same may have a broader impact on WPI inflation.

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

Given a scenario where in the intermediate inflationary pressures could still persist due to fuel price increase initiated by the Government, WPI inflation is likely to plateau around 7.00% plus mark for ensuing some months. This in our view may preclude the RBI from reducing its policy rates in its 2nd quarter review of monetary policy 2012-13, since the WPI inflation continues to remain over the comfort zone (of 6.00% - 7.00%) of the Reserve Bank of India (RBI).

In fact In the 2nd quarter mid-review of monetary policy the central bank has already reckoned the risk to WPI inflation and going forward the stance of the monetary policy will be conditioned by careful and continuous monitoring of the evolving growth-inflation dynamics, management of liquidity conditions to ensure adequate flows of credit to productive sectors and appropriate responses to shocks emanating from 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	(25 bps)	4.50%
Statutory Liquidity Ratio	(100 bps)	23.00%
Bank Rate	(50 bps)	9.00%

(Source: RBI website, PersonalFN Research)

Our View on inflation:

As mentioned earlier, we see inflationary pressures to persist due to increased prices of fuel and freight charges, which may trickle down to food items as well. Thus for about a quarter, we see WPI inflation maintaining an upward bias, where it could plateau around the 7.00% plus mark.

What should equity investors do?

In our view, with reforms being put in the forefront and focus given to fiscal consolidation, the Government has tried to encourage foreign investors to invest in India. It is noteworthy that the slew of measures adopted by the Government is expected to support India's medium to long-term growth prospects and will be a positive for India’s sovereign credit worthiness. Thus FIIs too would continue to exude confidence in India (a developing economy), at a time when the developed economy is reporting disappointing economic growth numbers. But the political environment would have to be monitored very carefully ahead of 2014 general elections, since there have been some political parties who have flagged their own ideologies while the Government in power has tried to push reforms.

On the global front, in the Euro zone, Greece is adding to most of the turbulence even today. The concerns that Greece’s economy would shrink again next year by 3.8% (making it the 6th annual contraction in succession) and that the debt-to-GDP ratio will rise to 179.3% in 2013 (a dauntingly high figure), is drawing a picture that Greece is in a worse state now, than even the most pessimistic forecast just six months ago. The IMF has already expressed that the global confidence will be very fragile and Euro zone crisis remain a key threat. So, although the ECB has agreed to buy bonds of the debt restrained Governments (once they have signed up for Euro zone bailout programme) and tried to restore confidence, the risk to the global economy remains – even to the emerging markets such as India, where growth has slowed down.

For the U.S., the IMF has cautioned that they need to do more to reduce their fiscal burden in the medium term. And in the U.S. with elections ahead (in November 2012), it remains to be seen how the elected President could address to this concern.

Thus given the fact the economic and geopolitical environment is dynamic, flagging concerns to risks to the global economy, we recommend you to stagger your investments. 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, until signs are moderation in WPI inflation are evident.

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% - 8.50% p.a.

What should investors in gold do?

The announcement of Fed’s stimulus measure to provide an impetus to economic growth has led to spur in prices of commodities, including gold. But at present although prices are looking elevated, one should continue to look at gold as a safe haven and invest in it the smart way. Going forward, since uncertainty looms around due to risk emerging from debt crisis in the Euro zone, the precious yellow would continue to enjoy its place of being a safe haven. Also the physical demand for gold is also likely to push prices upwards with the festive times ahead, with Dusshera (in October 2012), Diwali (in November 2012) and Christmas (along with wedding season as well). It is noteworthy that traditionally, the demand for gold in India (world’s top consumer of gold) rises in the last quarter of the calendar year, and this cyclicality could push gold prices further northwards.

Hence, nothing has changed for gold and we believe it will continue to maintain its upward trend in the long-term along with some sideways movement too.

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.