Indian rupee will continue to weaken as inflation rises

Step forward India – the latest country to bring us an inflation shock. Inflation, as measured by the Wholesale Price Index (WPI), shot up to a year-on-year figure of 11.05 per cent in the week ending June 7, from a year-on-year reading of 8.75 per cent in the previous week. That is a 13 year high for the WPI and compared with a consensus forecast among analysts of 9.8 per cent.

But this really should not have come as such a surprise. The move reflected a 10 per cent hike in India's oil price on June 4, which has now been captured in the WPI inflation barometer. As such, Goldman Sachs noted this weekend, this is a one-time upward shift in the WPI fuel component. What's more, the fuel component in the index had not been adjusted in the past three weeks to account for higher prices of jet fuel and naptha, which are not regulated in the same way in India.

Still, even after taking these technical factors into account, the rise in the headline rate was so far above analysts' expectations that it has triggered a full revision of Indian inflation expectations for the rest of the year.

The real point here is that inflation in double-digits can have a huge psychological impact on ordinary consumers, further fuelling inflationary expectations.

Indeed, Goldman is worried about the matter becoming a major political issue in India.

The bank reckons the Reserve Bank of India has been "behind the curve" and will now have to hike local interest rates.

But don't expect that to help the rupee in anyway. Says Goldman: "Given the negative sentiments of high inflation hurting foreign inflows and elevated global oil prices, we expect the rupee [INR] to continue to weaken. Our three, six and 12-month USD/INR forecasts remains at 43.9, 44.1 and 42.2 respectively."