Something happened this summer, inflationary heat finally made the RBI uncomfortable enough to increase the rates much before the monetary policy was due. So is this a new RBI that is no longer as cool towards rising prices? Those who think so believe that the RBI will hike interest rates yet again end of the month. But we do not think so; this RBI is inherently not in favour of a high interest rate regime. So why the mid-policy surprise? It appears the RBI wants to send out a signal of being pro-active and in control right before a delayed monsoon and energy price rise. So expect the interest rates to get higher only if the going gets really bad on the price front. Though possible, this is not likely.

The high WPI inflation has been due in large part to food price rises, which are now already trending down. What will be crucial is inflation in the manufacturing sector, this has been on the up-trend so far; we expect prices of manufacturing prices to be in the 6-7% range this quarter till September and thereafter move down to 5% levels by March.

What about the industrial production? IIP growth is also expected to have already peaked and will move down from May. Growth here has been powered by two segments – consumer durables and capital goods. Auto sales have been zooming up this past year, but these are set to slow down ahead with the fuel and rate hikes. Though we expect the consumer durables segment to come off its highs by the third quarter of this year, it will stay around the 10% growth levels this year, as income prospects continue to remain bright. The capital goods segment has seen phenomenal growth recently as it picked up steam from where it left off when hit by the crisis of confidence in late 2008. While part of the high growth is due to the base effect, all plans for expansion that had been put on hold are being put into action with the return of the India growth story. We expect that this abnormally high growth of more than 30% yoy in capital goods will taper down to more sustainable levels by the third quarter. This still leaves the IIP in a very comfortable zone of 8-10% growth in the year ahead. The RBI therefore can afford to put a wait and watch policy in its policy review this month end.

More than the rate hike, what may hurt expansion and consumption plans more can be a surge in fuel and input prices. We were pleasantly surprised to see the government bite the bullet and move towards market determined fuel prices, this was long overdue. According to EIA estimates, there are pressures for a modest rise for the rest of the year with a wide range of probable scenarios. They put a 37 percent probability of the December 2010 WTI price falling below $70 per barrel and a 25 percent probability of it exceeding $90 per barrel. But movement even in the 70-90 range will create significant volatility in prices in India now that we are going in for flexibility. So uncertainty with upward pressures persist in the year ahead and we need to watch out for that.

Even with all the uncertainty on prices and rate hikes, however, as we said in our last column, growth is back and it is here to stay.

Please see accompanying graphs here