UPA inflation is revving up and Rajan is caught in a pincer

Just when you thought inflation was coming down - sort of - we are getting completely different signals from the wholesale prices index (WPI). The CPI eased marginally to 9.5 percent, but the WPI numbers for August are truly worrisome. They not only show a rising trend despite slowing growth, but actually understate the future potential for more inflation.

The August WPI came in at 6.01 percent, and this despite the fact that manufacturing inflation hit a low of 1.90 percent on the back of slowing growth. Manufacturing accounts for nearly 65 percent of the WPI, which means that the balance 35 percent - mainly food and fuel - are driving inflation higher and higher.

What’s worse, this may not be the end.

Diesel prices rose 27.64 percent in August over the previous year, but even at this level, the losses on diesel for oil companies have hit a new high of Rs 14.50 per litre. Trying to shift this cost on to consumers will push fuel-led inflation to the stratosphere - despite slowing demand for diesel. This shows colossal mismanagement of the energy economy. At a time when industry is struggling, it is going to be hit by another energy blow.

The rise in onion and veggies is truly astounding - by 244.6 percent and 77.81 percent. Thanks to just these two items, food inflation is nearing 20 percent. It is now at 18.18 percent. While a good monsoon should be bringing down food inflation (hopefully), on the negative side the agricultural bounty will inflate the food subsidy this year beyond what the budget showed. That will build inflationary pressure on the demand side.

Food has a 14.33 percent weight in the WPI, and rice (up 20.13 percent) and eggs, fish and meat (up 18.86 percent) are leading the charge apart from veggies and onion.

What this clearly shows is that the UPA’s rural goodies and high subsidy bills - which will only worsen as election season nears - will push up inflation skyhigh even as growth falters further.

The Prime Minister’s Economic Advisory Council has brought down its GDP growth forecast to 5.3 percent, but even this could be an optimistic overestimate. Most research brokerages put growth in the range of 4-4.5 percent, max 5 percent.

Emkay Global Securities believes that “inflationary pressures could aggravate” and expects year-end inflation to rise to 7 percent.

Given this backdrop, and rising inflation, Reserve Bank Governor Raghuram Rajan will have to play hawk and maintain rates, if not actually raise them.

According to Rajeev Malik Senior Economist at CLSA, “more likely than not, the Reserve Bank will have to raise the repo rate (the rate at which it injects liquidity) when it dismantles its short-term interest rate defence (of the rupee). Also, global liquidity tightening will force countries to choose weaker exchange rates or higher interest rates. India’s repo rate needs to be higher, not lower, in order to improve deposit mobilisation. Ironically, India’s approach to salvage near-term growth, including by cutting interest rates, has not only hurt growth but also compromised macro stability. It is time for Governor Rajan to correct the bearings in order to return to macro sensibilities.”

The best course for Rajan, if he is to maintain the feel-good momentum of his last public appearance, is to focus on banking reforms to give the appearance of positivity even while raising rates. He could do this best by reducing marginal overnight rates (10.5 percent) and raising the policy repo rate above the current 7.25 percent.

It will be a tricky balancing act, but then the UPA government has given the Governor no room to manoeuvre. Rajan is caught between the devil of slow growth and the deep sea of UPA’s fiscal profligacy that has led to high inflation for years on end.