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The downturn continues

* September headline CPI inflation fell sharply to 4.35% from 5.3% in August, with flat-to-easing sequential momentum both in food and core components. Within food, perishables led the price correction. Core inflation rose mildly but with easing momentum, led by personal care. Housing prices saw a surprise sequential contraction. October inflation is tracking around 4.2%.

* We see FY22 inflation at 5.25%+ (RBI: 5.3%) with risk tilted slightly to the upside. Even assuming food inflation averages around reasonable levels, core inflation should average around 6.1-6.2%, outdoing headline inflation. We remain watchful of the pass-through of impending cost push pressures in core goods inflation and cost push via imported energy inflation, while re-openingled ensuing demand revival in select contact-sensitive household services could pressure core services inflation ahead. The steady recovery in industrial output reflects the traction in growth.

* The inflation-led dissenting noises in the MPC may continue. However, in the end, they may still choose to look through the spike in near-term inflation, with the monetary reaction function currently hinging more on the sustenance of growth revival. The focus of the RBI may remain on liquidity normalization measures amid the system liquidity deluge.

CPI inflation eases sharply led by food and base effect

As expected, CPI inflation eased sharply further, printing 4.35% after 5.3% in August (Emkay: 4.43% and Consensus: 4.53%) – in line with the RBI’s revised Q2FY21 forecast of 5.1%. The sequential momentum has remained subdued for food overall, driven mostly by the contraction in perishables. While vegetables (-1.6% m/m), meat & fish (-0.2%), milk (0.3%), eggs (-2.5%) and fruits (-2.6%) were much lower, nonperishable items were mostly up, with cooking oil, cereals and pulses up 2.2%, 0.2% and 0.7%, respectively. Overall, food inflation was 0.7% yoy, the lowest in 30 months, and it is likely to remain manageable in the coming months, contributing to lower headline inflation.

Separately, energy inflation was higher at 13.6% yoy (up 0.7% m/m), while the transport and communication (T&C) segment showed a mild trickle-down effect (0.1% m/m). Housing saw a surprise sequential decline. For the month ahead, the high-frequency mandi prices suggest an uptick in vegetables, while cereals, pulses and oilseeds seem to be slightly lower. Retail fuel prices have picked up sharply, and the cost of LPG cooking gas is also edging up. In all, the upcoming print should be tracked at ~4.2%.

Core inflation remains sticky but momentum moderates

Core inflation (ex-food, fuel and intoxicants) picked up moderately to 5.99% from 5.95%, though accompanied by a mildly lower sequential gain (0.23% vs. 0.53% earlier). Personal Care & Effects component was flat on a moderation in gold prices, while healthcare and education were sticky. We expect core inflation momentum to remain healthy, implying yoy print to touch above 6% through most of FY22.

IIP growth improves further to 11.9% in August

The 11.9% surge in Aug’21 IIP (Emkay: 10.4%, Consensus: 11.6%) was partly propelled by a favorable, albeit fading base. Activity levels have now jumped past pre-Covid levels, with the headline index now 3.9% above the Aug’19 level. Sequentially, momentum weakened across sectors except electricity. Sector-wise, manufacturing rose 9.7% yoy, led by electrical equipment, textile and machinery and equipment. Within manufacturing, Motor vehicles and transport equipment slowed in Sep’21 (-8% m/m,- 3.6% m/m) due to the chip shortage.

Mining grew by 23.6% yoy (-0.8% m/m) and electricity output rose 16.1% yoy (2.2% m/m). Among use-based items, primary goods, capital goods and infra/construction were up 17%, 19.9% and 11.1%, respectively, while consumer non-durables turned positive (5.2%) after contracting for two straight months. All the use-based sectors surpassed the levels since Sep’19, except for consumer durables (3% below pre-Covid). We expect demand for industrial output to improve in the coming months on a net basis.

FY22 CPI to average 5.25%+ but noises within MPC to rise

Base effect will dominate the rising fuel costs, input cost pressures, and seasonal turn in some food prices in the coming months, but it will likely rise toward 5.85%+ later in the fiscal year. While we maintain our forecast of 5.25% (RBI: 5.3%) for FY22, we reckon supply-side bottlenecks, higher imported commodity inflation and high pump prices will pose a countering upside pressure on inflation.

The noises within the MPC may rise as the pass-through of impending input price pressures and the ensuing demand revival in contact-sensitive household services keep core goods inflation under pressure. However, ultimately, with the monetary reaction function currently hinging more on the sustenance of growth revival, the RBI’s reaction function on key policy rates is unlikely to change this year, especially as the pass-through to output prices and core inflation is still somewhat tempered, given the output slack.

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