>INFLATION (MERRILL LYNCH)

Crouching inflation, not-so hidden RBI

■ RBI will likely reverse easy money policy January/April…
We believe that rising inflation risks – such as today’s fuel price hike – buttress our expectation of the RBI reversing its easy money policy by January/April 10, if our end-09 bottom out materializes. Swing factor: monsoons, with a 5% swing in agro prices impacting inflation by 150bp (Table 5). By the way, do read our oil analyst, Vidya Ginde, on the stock impact of today’ fuel price hike.

This, in turn, leads us to take off our 25bp July policy rate and 50bp October CRR cuts (Chart 1). RBI Gov Subbarao, of course, has been flagging the need to “think” of an exit strategy as growth risks diminish to ward off potential inflation. After today’s hike in petrol (Rs4/l or 9.8%) and diesel (Rs2/l or 5.8%) prices, Delhi also may not insist on further easing, given negative real policy rates and excessive monetary expansion (Chart 2). In any case, Delhi has successfully just orchestrated a 50bp cut in bank prime lending rates (PLR) to support growth.

■ … as sugar, oil mounts risks to 5% inflation expectations…
We continue to expect WPI inflation to turn up after September, after mid-09 deflation, to strain the RBI’s 5-5.5% comfort zone by March (Chart 3). In fact, we have ourselves hiked our March 10 inflation forecast to 6.1% from 5.2% (Table 2). To begin with, today’s oil price hike – adding 40bp to inflation directly and 80bp overall (Table 3) – was at the upper end of our 5-10% fuel price hike expectation here. While we expect Delhi to avoid further oil price hikes this fiscal, the gap between the implied crude price of domestic fuel prices and the ruling international crude price remains substantial (Table 4). Besides, we up our sugar price forecasts after initial cropping data revealed a 3% decline in farmland (Table 5). Do read our last inflation report here.

■ … but still expect soft lending rates to support growth
This, of course, begs the question: would RBI action not push up lending rates to impact growth? Not really. We actually expect soft lending rates to persist into 2HFY11 to fund a return to 7% growth. Do read our growth upgrade here.

First, we expect the RBI to calibrate economic recovery with price stability.

Second, we believe that monetary action, by now, is priced into gilts. In fact, swaps are actually signaling 09 tightening, which we find too early.

Third, even if yields do react, we believe that the still too high 475bp spread between bank prime lending rates and the benchmark 10y should cushion lending rates. The PLR-10y spread usually averages ~400bp.

Finally, the last round of lending rate cuts have been funded by deposit rate cuts that have reduced banks’ cost of funds.

To see full report: INFLATION