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Inflation reverts above 5%, while industrial activity depicts patchiness

* February Headline CPI inflation expectedly rose ~100bps to 5.03% led by unfavorable base effect, much lower sequential correction in vegetable prices, higher energy and transportation prices and select sequential increase in core goods inflation. Core inflation surge of 5.72% from 5.16% prior, led by higher sequential gains in health, recreation, and transport costs. While the overall demand condition remains patchy, we believe that continued traction in activity, possibly improving producers' pricing power and rising input costs weigh on the underlying inflation.

* Despite Mar’21 inflation tracking 5.5%+, the RBI's Q4FY21 forecast could see a 25- 30bps cut, in our view. We think that the headline inflation may average ~4.5% in FY22E vs. ~6.2% in FY21E, assuming that the food inflation normalizes. We see core inflation outdoing headline inflation through most part of FY22, averaging 5.2%, same as FY21. We, however, remain watchful of risks in the form of cost push pressure in non-food and non-perishable goods, seasonal upside in food prices in summers and demand-led better pricing power.

* Separately, IIP lost momentum again in Jan’21 and contracted 1.6%, dragged down by poor manufacturing activity and muted consumer demand. However, we believe that this is a temporary blip as activity indicators show improvement in Q4FY21.

CPI inflation surges to 5%+ After having surprised the markets pleasantly on the downside for three consecutive months, inflation surged again in February. The headline print came in at 5.03% -- 100bps higher than the print seen in February (Emkay: 4.86%, Consensus: 5.0%). The expected surge in inflation was led by unfavorable base effect, much lower sequential correction in vegetable prices, higher energy and transportation prices and select sequential increase in core goods inflation. The gap between rural (4.2%) and urban (5.96%) CPI inflation widened, partly reflecting intense volatility in food and fuel prices. Food inflation rose to 3.87% on an annualized basis from 1.9% prior, led by slower sequential contraction in vegetables and pulses, and pick-up in oils and fats, while ex-pulses protein complex eased substantially amid avian flu fears. On annualized basis, vegetable inflation contracted 6.3% (-3.5% MoM) after -15.8% in Jan’21. High-frequency mandi prices suggest a further uptick in prices of edible oils and milk and slowing of sequential fall in perishables, while eggs, meat and fish prices may continue to ease through Mar’21. However, an unfavorable base may lead to a sharp rise of 50-60bps in headline print in Mar’21. Core inflation edges down, albeit marginally.

Core inflation surge led by both goods and services Core inflation (ex food, fuel and intoxicants) continued its uptrend and rose sharply to 5.72% from 5.16% in Jan’21, driven by higher sequential gains in health, recreation, and transport costs. Personal Care and Effects moderated sequentially, partly also led by correction in gold prices. Overall, a gradual but patchy recovery in economic activity, possibly improving producers’ pricing power at the margin, rising input costs and higher administrative fuel costs could weigh on core inflation, in our view. However, easing disruptive supply logistics and wide output gap should ensure a limited upside in the underlying inflation.

IIP growth contracts again, showing patchy state led by manufacturing IIP unexpectedly contracted 1.6% in Jan’21 (Emkay: 1.1%, Consensus: 1.0%) just after positive growth of 1.3% in Q3FY21, which was the first positive quarterly growth in six quarters. However, we see this as a temporary blip amid continued improvement in activity indicators in Q4FY21. Industry-wise, the contraction was led by manufacturing (-2.0%) and mining (-3.7%), while electricity was up 5.5%. Sector-wise, consumer non-durables contracted sharply by 6.8% and capital goods production by 9.6%. Intermediate and construction goods were mildly up.

The MPC to draw comfort, but further conventional easing looks elusive Despite resumed uptrend in CPI inflation, the RBI’s Q4FY21 estimate of 5.2% could see a 25-30bps cut. If the food inflation normalizes in the next year to sub 3% (from 8%+ in FY21E), the headline inflation could average 4.5% in FY22E vs. ~6.2% in FY21E. However, risks of increasing input costs, higher commodity prices and seasonal upside in food prices and better pricing power remain key risks to inflation. We see core inflation outdoing headline inflation through most part of FY22, averaging 5.2%, same as FY21. While this could worry the policymakers, the policy stance will likely remain accommodative on both rates and liquidity front in CY21.

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