The provisional headline inflation rate (wholesale price index, WPI) decelerated to 6.87 per cent YoY in July 2012 from 7.25 per cent YoY in June 2012. The seasonally adjusted WPI index was up 0.2 per cent MoM in July (vs. 0.3 per cent month-on-month in June based on provisional data).

The headline inflation in July was much lower than consensus expectations of 7.2 per cent and our expectations of 7.2-7.4 per cent. The deceleration in headline inflation was primarily led by lower fuel inflation – fuel index declined by -1.5 per cent MoM in
July. The final inflation data for May 2012 was unchanged at 7.55 per cent YoY as reported earlier.

Non-food manufactured inflation that the Central Bank monitors accelerated to 5.44 per cent YoY in July from 4.85 per cent YoY in June. The increase in non-food manufactured inflation component also partly reflected base effect – the non-food manufactured index
had declined by 0.1 per cent MoM in July 2011.

We believe apart from lower global commodity
prices, the delay in pass-through of administered fuel and electricity price hikes – and thus the consequent
second-round impact on core inflation – has been a key force keeping WPI core inflation at steadier levels.

According to our oil and gas analyst, Vinay Jaising, if the government were to achieve its budgeted oil subsidy estimates (based on current oil futures prices and
current exchange rate), regulated fuel basket prices (including diesel, cooking oil and cooking gas) would need to be hiked 29 per cent (adding 183 bps to WPI inflation).

Similarly, if the government were to ensure that losses of state-owned electricity distribution companies were brought down to the past trend of 0.3 per cent of GDP from
the current 0.7 per cent of GDP, the required hike in electricity Tariff would lift WPI headline by another 50 bps.

The fuel index declined by -1.5 per cent MoM in July, reflecting lower prices of light
diesel oil (-10 per cent MoM), furnace oil (-8 per cent MoM), naphtha (-7 per cent moM), aviation turbine fuel (ATF) and petrol (4 per cent MoM each). Fuel inflation decelerated to 5.98 per cent YoY in July from 10.27 per cent YoY in June. The lower YoY fuel inflation can be partly explained by the base impact of last July’s adjustment

(increase) to administered fuel prices.

We believe the decline in the fuel index reflected in the
non-administered component could stem from the lagged pass-through of the decline in global crude prices in June compared with May (-12.8 per cent MoM in dollar terms).

Food inflation (primary and manufactured) remained steady at 9.5 per cent YoY in July compared with 9.4 per cent in June. Primary food inflation,

though remaining high, decelerated to 10.1 per cent YoY in Jul compared with 10.8 per cent YoY in the previous month. However, manufactured food inflation accelerated to 6.3 per cent YoY compared with 5.8 per cent YoY in June.

We believe poor progress of the monsoon in the season thus far (15 per cent below normal) and consequent adverse impact on area under cultivation (-8.8 per cent YoY) means that the summer crop output growth will be significantly below our forecast. Excess stocks of rice will help to reduce any adverse impact on prices, but lower area under coverage for pulses, coarse cereals and oilseeds will keep food inflation elevated. Indeed, food prices as measured by daily wholesale food prices (available from Department of Consumer Affairs) have continued to accelerate in July and August (to date) as well.

We believe that to assess the trend in inflation expectations, CPI is the most important measure. In the past, price levels as measured by Wholesale Price Index (WPI) and CPI (Industrial Workers) usually tracked a similar trend – but over the last three years, a huge gap has opened up. Hence, we believe that WPI/core WPI inflation is not a sufficient measure to assess the outlook for inflation expectations.

Headline CPI inflation (industrial workers) has reaccelerated since March this year. CPI (IW) remained high at 10.05 per cent YoY in June compared with 10.2 per cent in May and April, 8.6 per cent in March, 7.6 per cent in February and 5.3 per cent in January. Non-food CPI inflation has also remained high at 9.5 per cent in June compared with 9.7 per cent in May, 9.8 per cent April and 9.1 per cent in March. This indicates that domestic price pressures remain elevated.

In our view, the high government deficit and strong growth in rural wages (at ~20% YoY for last three years) are key factors keeping inflation expectations high. Indeed, the RBI’s survey of households indicates that inflation expectations still remain high at double-digit levels. Persistently high inflation expectations are not surprising considering the trend in CPI.

Beyond our view that summer crop output growth will be significantly below our forecast, the continued deficiency in rainfall trend would affect water reservoir levels and have an adverse impact on the winter (rabi) crop outlook as well.

Along with the adverse domestic conditions, the external environment has also deteriorated further, with more downside to DM growth. We thus see downside risk of about 30-60 bps to our current estimate for GDP growth of 5.8 per cent in F2013.

What about policy response? We believe the RBI is likely facing a dilemma on policy action in the current stagflation-type environment. Growth is slowing – yet inflation remains a challenge. WPI inflation has remained above the RBI’s comfort zone of 5-5.5 per cent for past 32 months now.

Indeed, we continue to see inflation around the 7 per cent mark for the next few months, as pressures from food prices will keep the headline number high.

More importantly, we think the high CPI inflation and inflation expectations will not provide any comfort to the RBI to cut policy rates in the next meeting on September 17.