Inflation to stay at high levels in FY11

Prime Minister Manmohan Singh said last month that headline inflation would fall to 5-6% in December but forecasts by policy makers have been consistently off the mark in the past.

Here are scenarios for how headline inflation may develop over the next few months and the possible impact on fiscal and monetary policy.

HEADLINE INFLATION STAYING IN HIGH SINGLE DIGIT IN FY11

Possibility: This is the most likely scenario.

The wholesale price inflation has been stubbornly high, driven by food prices and by increasing demand pressures.

In such a situation, analysts and market participants mostly expect the central bank to go for aggressive monetary tightening by as much 125 bps in fiscal year that ends in March 2011.

The repo rate now stands at 5.25% and the reverse repo at 3.75%.

The market has already priced in a 25 bp rate hike in July. The RBI will come under increasing pressure to hike rates between policy meetings if inflation stays high, but a hike before the July 27 quarterly policy review is unlikely due to a liquidity squeeze on banks.

Food prices are expected to stay high due to high minimum support prices, a political imperative.

A severe heat wave in north India drove up prices of food and vegetables in May. Inflation on manufactured products was a high 6.41% in May and expected to stay so due to demand.

A hike in fuel prices will put even more upward pressure on prices, one reason why the government has kept a move to free domestic fuel prices on hold.

Sharp revisions in recent inflation data have added to the perception that the government and the Indian central bank are unable to tame prices. The March headline inflation figure was revised from 9.90% to 11.04%.