The Reserve Bank today said falling rupee will likely offset the positive impact of above-average monsoons on inflation.
The rupee so far has lost over 20% since the beginning of this fiscal, and today it closed down with a loss of 44 paise at 64.55 to the dollar.
As of August 13, the monsoon was 10% above normal with 85% of the Met divisions recording more than normal to average rainfall, helping improve the Kharif sowing by 11%, the RBI said in its annual report over the previous year.
In the July monetary policy review RBI has pegged annual inflation at 5%, which though is not an official price index target.
"Although headline inflation had moderated in Q1 to an average of 4.7%, risks on the inflation front are still significant.
"First, this is evident in a rebound in inflation to 5.8 per cent in July. Creeping inflation pressures are visible arising from rising food and fuel prices, the latter in large part due to the exchange rate depreciation, which was evident in food inflation resurfacing since May," the RBI said.
On the global commodity prices, the report said, "The outlook largely remains benign, risks of price increase on-shore have increased following the rupee fall and firming up of global crude prices in July. Therefore, some price pressures may build up in H2."
The report further warned that while moderate MSP increases and the good monsoons give hope that inflation will be contained, if high food inflation persists into H2, the risks of generalised inflation could become large.
"Also, the pass-through of the 11 per cent fall in the rupee in the first four months of FY14 is incomplete and will put upward pressure as it continues to feed through to domestic prices. Though exchange rate pass-through has declined in recent years, increase in inflation can occur, given the significant depreciation of the rupee," it said.
The RBI further said while WPI inflation has moderated, CPI inflation remains close to double-digits.
However, it underlined that overall inflation outlook appears to be better than the previous year as non-food manufactured products inflation at 2.4% in July is within its comfortable zone.
It also warned that due to the good rainfall, the demand-supply balance may be disturbed due to more demand from the hinterlands. "Demand deceleration continues, but rural demand may stay robust in the wake of a likely good crop on the back of normal monsoon.
"The normal monsoon, however, has taken a major risk off the horizon, although the renewed upsurge in food prices in the first four months of FY14 implies that a close vigil is necessary so that the relative price change does not affect the general level of prices," the central bank concluded.