The Wholesale Price Index (WPI)-based inflation for the week-ended May 30 came in at 0.13% Y-o-Y, in line with expectations (Edelweiss: 0.09%; consensus: 0.10%) and lower than the previous week (0.48%).

Inflation hits ground zero
The Wholesale Price Index (WPI)-based inflation for the week-ended May 30 came in at 0.13% Y-o-Y, in line with expectations (Edelweiss: 0.09%; consensus: 0.10%) and lower than the previous week (0.48%).

Negative inflation likely next week; strong upside risk over medium term
WPI has by and large been on the rise since mid-March. Food prices have been the primary factor driving up the overall WPI during this period. Rise in prices of most industrial commodities has so far been limited during this period. However, in recent weeks, prices of fuel and certain metals in the global market have surged significantly. Although the jump has brought in additional upside pressure on inflation, Y-o-Y WPI inflation is set to enter negative zone from the week ending June 6 (data to be published on June 18) onwards. We expect a spell of negative Y-o-Y inflation for two-four months from that point onwards. The lowest point of WPI inflation can be around -2%. The trajectory of a rapid fall in inflation from Q3FY09 onwards to around 0% by mid-2009 had been exactly on expected lines (refer our note, Inflation: From dizzying heights to ground zero, dated November 4, 2008).

However, continued liquidity and possibility of greater pass-through of increase in oil and commodity prices may significantly push it beyond the current expectation over the next 9-12 months. Food prices have been continuously on the rise, as reflected in the high CPI level. We see a possibility of WPI inflation touching mid-single digits with an upside risk by March 2010 and also acknowledge that the possibility of WPI inflation touching double-digits again in FY11 cannot be ruled out.

End of RBI action; mixed trends ahead for interest rates
The government and Reserve Bank of India (RBI) have repeatedly indicated their priority for a benign interest rate environment. However, RBI is almost done with its policy rate cut cycle. We do not expect any further cuts in policy interest rates from the central bank. At the most, there can be just one more token cut of 25bps in repo and reverse repo rates in RBI's July policy for uplifting sentiments.

On the other hand, to enable banks to reduce their deposit rates, the government may reduce administered interest rates for small savings schemes like postal deposits. There is constant moral suasion from the government on banks to reduce lending rates. With additional headroom for lower deposit rates, pressure will be more on banks to reduce rates. We believe headline PLR may be reduced 50-100bps by many banks over the next one month.

However, we reiterate our view that the likely overshooting of government borrowing and gradual resurfacing of inflation expectations in CY10 will keep upward pressure on market interest rates like bond yields. That could lead to a situation where actual softening of lending rates will be much less despite a significant reduction in the headline PLR. On the whole, though deposit rates and the headline PLR may dip significantly, softening in actual lending rates will be much less, while bond yields will rise over the next three-six months.