India importing high inflation

Though headline wholesale price inflation for the week to January 31 declined to 5.8% y/y from 6.12% previously, it has consistently surprised on the higher side in each of the last four weeks. At the same time, the central bank and the ministry of finance have reiterated that wholesale price inflation will fall within the 4%-4.5% range by March-end. The reason behind that contention is a sharp base effect lined up ahead. Increasingly, however, the market is expressing doubts about that forecast. Though weekly numbers have too much noise to make anything of them, our estimates still suggest that RBI's prediction will be proved right. Even if it does not, the margin of the overshoot is not likely to be big.

A key question is whether a March-end figure of 4.7% as against 4.45% will change things in a big way. Most will agree that this outcome in itself will not materially alter the medium-term inflation scenario. That said, it could be argued that the authorities might lose face having overemphasised this forecast in the public arena. Here again, it needs to be recognised that forecasts are just forecasts. Unless the divergence is by a margin that cannot be explained away as statistical aberration, the credibility argument does not hold water. That is not to say that the market will not react negatively. The key issue is whether any sell-off would be sustained.

To answer this question, we need to gauge the broader inflation outlook. In this context, it is important to investigate the reasons behind these consistently higher than expected figures. Manufacturing inflation - considered a proxy for core - has been jumping in the recent past. Narrowing down further, the Basic Metal Alloys and Metal Products category is causing concern. Prices in this category have risen by about 19.5%. That is reflective of the international metal price cycle. Another important variable is the hike in fuel prices effected on the back of firm international oil valuations. In fact, almost 45% of the price rise being witnessed is a result of international factors. India is importing high inflation. Overheating domestic demand is not a problem currently.

In our view, the global metal price cycle is close to its peak. While prices will remain firm, they are unlikely to rise much from current levels. Oil prices are also expected to remain stable. Thus, surging inflation is not our core scenario and we still believe that it will average around 5% in 2004.

What if we are wrong? How will the Reserve Bank respond to imported inflation when the economic recovery is only just beginning? Choking off domestic demand by tightening reserve requirements or hiking interest rates is not the right answer in our view. Needless to say that it is not politically feasible either. The other option is to let the INR appreciate. Exchange rate adjustment seems to be the correct response to internationally transmitted inflationary pressures. However, that option also has its political pitfalls in form of opposition from the exporter lobby. The policy response will depend on which alternative is politically less problematic. Exchange rate appreciation fits this prescription. Thus, if our inflation outlook is too dovish, short the dollar against the INR and buy into any bond market sell-off that results.