The June Consumer Price Inflation(CPI) slipped to 1.5% YoY from 2.2% in May. With this, the headline CPI inflation has fallen below the lower bound of RBI inflation target range of 4% +/- 2% for the first time. Food inflation declined to -1.2% vs -0.2% last month led by a decline in pulses. Fuel inflation also eased to 4.5% from 5.5%. Core CPI inflation (CPI ex fuel and food) declined to 3.9% vs 4.3% as well.
Citi economist expect CPI inflation to rebound from these lows as vegetable prices normalize, the positive base effect turns adverse and also the impact of 7th pay commission implementation (likely to push headline inflation up by 50bps over next six months). On the disinflationary side, GST, normal monsoon and moderate MSP hikes is likely to keep a check on food inflation. Overall, they expect CPI inflation to gradually inch towards 4-4.5% over Jan-Mar’18.
Broad based decline in CPI inflation (%YoY)
Source: Citi Research, CEIC, CSO.
Core inflation had stayed in a 20bps range around 5% for almost two years before October 2016, when the last rate cut was effected. Post October, the core inflation measure has actually declined by 100bps. This persistent drop in core CPI should provide more comfort to RBI. Citi economists believe that there is a strong case for an August rate cut of 25bps. In their view, the March 2018 inflation could be below 4% (adjusting for the transitory effect of 50bps from the 7th pay commission HRA increase). Assuming a 125-175bps real policy rates, the target repo rate would be 5.75% [Inflation(4%) + Real Rates(175bps)]. With current repo rate @ 6.25%, this may open up space for a cumulative 50bps rate cut in in FY18.
RBI may still hold back in August, given their preference for higher real policy rates, fear of sharp reversal of food inflation given large scale farm loan waiver announcements and uncertainty over possible monetary tightening in the developed world. However, Citi economist assign a very low probability to such a scenario.