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Event update: Economy - Steady retail inflation but core hardens, rate easing may halt

Marginal fall in CPI inflation to 3.15%, but core is rising; maintain our yield hardening thesis

Easing of inflation due to fuel components: CPI inflation for Jul’19 at 3.15% was marginally lower than 3.18% in the previous month. The urban and rural inflation break up stood at 4.2% and 2.2% respectively.

The decline in inflation was mainly contributed by fuel segment deflation of 0.36%, a decline from an inflation of 2.2% in the previous month. Rest of the components saw rise in inflation, along with steep rise for miscellaneous component, which increased to 4.7% from 4.5% a month back (Miscellaneous includes household goods and services, transport & communication, recreation, education and personal care). Food inflation was mostly unchanged at 4.3%, led by high urban food inflation at 5.3%.

Core inflation has bottomed: Various measures of core inflation saw an uptick in Jul’19. The basic core inflation (CPI ex food and fuel) increased to 4.1% (up 12bp), core-core (ex food, fuel & light and fuels for vehicles) increased to 4.5% and super core (core-core less house rent) stood at 4.4%. Average of all three measures of core inflation was 4.3%, 10bp higher than the average of previous two months.

Outlook-Rate easing may take a halt: Bottoming out of core inflation from the lows of May’19, following a consistent decline from ~6% in Oct’18, portends that consumption demand at a wider level may be improving after months of weakness. Importantly, the inflation for miscellaneous items (includes various services and personal care items), and tobacco & intoxicants have seen a noticeable rise from the recent lows.

Also, while the fuel segment has resulted in volatility in headline inflation, the non-core components has seen rise in food inflation, especially in the urban areas.

Basis the current average core inflation of 4.4% (estimated for Aug’19), the real policy rate following the latest 35bp repo rate cut to 5.4%, now stands at 1%. This is lower than RBI’s desired real rate of 1.5-2.0%. If instead, we consider the more volatile headline inflation (not an appropriate measure for monetary policy targeting), the real rate works out to be 2.2% (repo rate of 5.4% less headline inflation of 3.2%). This is close to the upper bound of 2% desired real rate.

Lagged correlation of RBI’s rate actions is higher with core inflation movements than with headline inflation. Hence, at the current levels, the real repo rate of 1% (based on core inflation) is lower than the desired 1.5-2%, implying a fairly accommodative stance.

In addition, anticipated fiscal stimulus in form of higher sending, will add to the momentum of core inflation. While for headline inflation, the non-core fuel inflation is subject to movement in global commodity prices, the recent depreciation in Indian rupee will have inflationary pass-through impact. Moves by the US to ease pressure on Chinese imports can also add to this thesis.

Overall, if our prognosis of rising core inflation is correct, then RBI may halt its easing after the cumulative 110bp rate cuts since Feb’19 and allow the transmission to happen. INR deprecation, higher government spending and bottoming out of core inflation will lead of hardening in Gsec yields, which has seen a severe flattening trend since Oct’18. India 10-year benchmark has already hardened to 6.62% from the recent lows of 6.3% and we maintain that it could further rise to 7% in the near future. Since we had largely anticipated this scenario, we have maintained our underweight (UW) position in PSBs and NBFC space.