The Wholesale Price Index (WPI)-based inflation dropped to 6.55 per cent last month from 7.47 per cent in December last year. The decline in the headline inflation rate to its lowest level in 26 months in January has evoked a wide range of reactions.

At one extreme, it seems to heightened the already buoyant mood in the stock markets. The two benchmark indices, the Sensex and the Nifty, have recently been climbing to levels not seen in a long time.

After being in the doldrums for most of 2011 — Indian stock markets were among the worst performers last year — they have, since the beginning of the New Year, been right at the top of foreign institutional investors' preference lists.

Like many things connected with the stock markets, there is no rhyme or reason to explain, leave alone rationalise the behaviour of large investors. Apart from the news on inflation, there is very little in recent macroeconomic data that could spur stock markets at least to the extent seen last week.

On the contrary, the CSO's advance estimate of GDP growth points to an economy growing at below 7 per cent during 2011-12.

The Index of Industrial Production (IIP) for December, 2011, released soon after, does not by any means indicate an industrial recovery. (year-on-year growth in industrial production slumped to just 1.8 per cent).

Although the IIP series are known to be volatile, the December figures reinforce the perception of an industrial slowdown. Certainly that is not something for the stock markets to cheer about.

The problems in the eurozone countries persist. The U.S. economy might be faring better than what was anticipated but growth was still anaemic.

As far as Indian stock prices are concerned, the possibility of capital flows reversing is real. That should normally suppress any uncalled-for optimism. Moreover, the Union Budget is less than a month away. The pre-budget sentiment in the markets has traditionally been far less upbeat than what it is now. Punters usually hedge their bets ahead of the most important economic news.

The government has been more circumspect in reacting to the inflation data. Finance Minister Pranab Mukherjee was confident that the inflation rate would moderate further in the coming months. He, however, expected the prices of manufactured goods to be more gradual compared with the fall in food prices.

Will the lower inflation figures prompt the RBI to commence the long awaited phase of interest rate reductions? A monetary policy review is due in March and on the face of it, the January inflation figures do improve the odds for a round of monetary easing.

That said one needs to look at the factors that have brought down the inflation rate in January .Will they endure?

Rating agency Crisil in a recent incisive report points out that core inflation (non-food manufacturing) has now declined for the second consecutive month. This means that the impact of past rate hikes on demand slowdown has begun to reflect in overall inflation. Forecasting WPI inflation for 2012-13 at 5.8 per cent, Crisil says that the lower inflation vis-a-vis 2011-12 is mainly due to a high base and low pricing power of corporates (due to sluggish domestic demand). Indeed, a favourable ‘base effect' is behind the recent fall in inflation. It will reverse from February onwards.

Moreover, the possibility of an upward revision in domestic fuel prices and the likely reversal in the seasonal decline in food prices will exert pressure on inflation.

The role of expectations

A recent RBI survey points out a majority of households expect inflation towards the end of 2012 to be higher than a year ago. The fact that inflation expectations remain high despite the decline in January shows that most of those surveyed think that its fall is temporary, a one-off affair. Expectations will come down only when inflation stabilises at lower levels.

The connection between inflation expectations and actual inflation is well known. Key decisions by households on how much to consume now and how much at a later date will be influenced by their inflation expectations. Likewise, expectations have a significant influence over companies' decisions on setting prices.

They also influence wage negotiations. If people believe high inflation is here to stay, they would demand higher wages.

C. R. L. NARASIMHAN

The news of a decline in inflation has created an unjustified stock market euphoria. Whether inflation will remain at the current level will partly depend on how high inflation expectations are doused.