Even as inflation falls, the case for rate hike remains

Question: When is a falling inflation rate not as good as it looks?

Answer: When it does not send the right signals to policymakers.

Here’s the catch: the July wholesale prices index (WPI) is down to 9.22 percent from 9.44 percent in June, and this has happened because of a fall in food and fuel inflation.

Good news? Sure. But manufactured products inflation - the kind that is amenable to monetary policy correction - is still rising, and this means the case for raising interest rates is still strong.

[caption id=“attachment_61961” align=“alignleft” width=“380” caption=“Manufactured goods inflation is in part a reflection of demand side pressures pushing up prices.AFP Images”]  [/caption]

In July, manufactured products inflation went up to 7.5 percent from 7.4 percent in June. Last year, the rate was even lower at 5.8 percent in July 2010.

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This clearly shows that the battle against inflation is only half won as yet.

Manufactured goods inflation is in part a reflection of demand side pressures pushing up prices. Given that monetary policy is more effective in dealing dousing demand, and absolute levels of inflation are still high even with the latest drop, we could see another rate hike next month. The next Reserve Bank policy review is scheduled for 16 September.

Nevertheless, let’s celebrate the positive. A look at inflation for the year so far -April-July 2011 - indicates that the index has firmly come off. At an average rate of 9.2 percent, it is a decline of over one percentage point since the same period last year.

Secondly, the component of inflation that has shown a decline is food inflation - which has seen runaway price increases for almost two years now. Food inflation has now fallen to a 28-month low of 8.2 percent.

Fuel inflation has also subsided to 12 percent from 12.8 percent during June, thus helping overall inflation.

However, while the first signs of winning the battle against inflation are visible, there is enough to be vigilant about as well since “core” inflation is rearing its head. Manufactured products’ inflation has reached a 33-month high after rising for the third straight month.

This is supported by a recent spurt in the Index of Industrial Production (IIP) numbers, which rose by a strong 8.8 percent in June, even though there is a secular downtrend.

But even on food and fuel, it is best to keep fingers crossed. From next month, the base on which inflation is calculated will be less supportive. And for the week ended 30 July, food inflation has actually risen, raising a concern for the future.

In sum, then, while inflation is clearly on the decline, the absolute figures still remain high, keeping alive the chance of a policy rate hike.

Inflation (%, annual growth)