Fallouts of Inflation

Near term macro challenges – Indian economy

Global inflation is surging, roiling the Indian economy. Markets fear that steep rate hikes could be the only way out

The Ukraine-Russia conflict is fuelling higher prices of food and commodities. We have no visibility as to how long the sanctions could remain in place or what course the political situation in Ukraine will take. While countries have spoken about refusing Russian oil and increasing supplies from other countries, oil prices so far have hardly shown signs of coming down. Russia has signalled lower prices for some buyers, but transporting these supplies is a huge logistical issue. On the other hand, natural gas prices have been incessantly rising, giving authorities in Europe the chills.

One of the effects of all this is inflation trending uncomfortably high. The impact will be felt around the globe. Already, CPI inflation in March in India shot up, nudging 7%, much above the consensus estimates of 6.28% with higher figures reported in both food and non-food inflation.  Core inflation rose too to 6.32% driven by personal care (gold prices), clothing and household goods. The downside on the inflation front is that it may not abate in the next few months. Supply-chain price pressure, higher transportation costs could continue to pile the pressure. For this reason, the RBI may have to step in with rate hikes to cool prices.

Prima facie, the recently released Consumer Price Inflation of 6.95% for March does not seem too high. India has dealt with higher inflation in the past. However, the RBI had projected 5.3% inflation for FY22, and the recent figure has already exceeded the broad target range. The next one or two quarters could track a similar trajectory.

In the coming months, base effects should ease for some other segments as well, but second order effects (e.g., higher freight rates) and a likely weakening of the INR can provide an upside pressure to inflation. While the MPC’s 1Q forecast of 6.3% may be beaten, the challenge would be in finessing out the “one-time” contributors and in this backdrop RBI’s projection of 5.7% in FY 23 appears highly optimistic.

Large rate hikes calling

Last year, the price of oil averaged around $71 a barrel; today crude trades at $108. Hence, some economists have forecast more than 6% inflation in FY23, far higher than the RBI’s 4.5% forecast. Of course, much will depend on whether oil prices ease in coming months. But if global inflation persists, the growing worry is that rate hikes in India would be about 100 basis points.

US consumer prices surged 8.5% in the 12 months ending March, from 7.9% in February. This is one of the highest levels, and the biggest jump since 1981. In the past the US Fed has reacted a mite slowly to rising inflation, though it has started to take cognisance of the fact that inflation is real and could prove to be challenging. Its recent 25-basis-point hike is a step in that direction. Fed officials hinted at more rate hikes in coming quarters.

However, in India the RBI has kept the policy rate unchanged at 4 per cent since February 2022. The MPC has pointed out that inflation is expected to peak in Q4 FY22 (within the tolerance band), then soften in H2 FY23, closer to the target. Nevertheless, with US interest rates being hiked, India will find it difficult to keep rates low or unchanged in coming quarters. India’s 10-year bond yield surged to about 7.2%, the highest since May 2019.

Macros slide

While export growth remained strong at 20% in March 2022 taking FY 22 exports to a record $420 bn, aided by growth in exports of engineering Goods and chemicals, higher petroleum prices, trade deficit rose to $4.9 billion taking the total deficit for FY 22 to a record deficit to USD $192 bn. India’s current account deficit widened to 2.7% of GDP from 1.3% in Q2 FY22. The run up in global commodity prices in the third quarter is one of the factors that led to the swelling deficit.

India’s economic output is another worrisome factor. In February, the Index of Industrial Production grew a meagre 1.7%, against the widely expected 2.7%. The low base has not helped much. Most sectors have seen declines. One reason could be supply disruptions, leading to higher input costs. Ahead, recovery could be hit by lower consumption, squeezing corporate profitability.

All these point to challenging times ahead on the macro front.

Markets resilient

The investment climate, though, is not that bad. After a scare on February 24 when the Nifty 50 dipped to a low of 16,247, the bellwether clawed back to about 17,500 in April. Despite the anticipated rate hikes, domestic investors are keeping faith in stocks. The recent strength in the stock markets point to the fact that investors are more than willing to give the benefit of the doubt to economic growth holding up despite the inflation.

The other view is that the market sees the US Fed as successfully navigating the inflationary era and making a much-needed soft landing. That’s one huge factor that longer-horizon investors will certainly hope pans out.

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