Elevated commodity prices have raised concerns of persistently high retail inflation in a country like India, which imports the bulk of its crude oil requirements.
With consumer price inflation (CPI) at a 17-month high of 6.95 percent in March and wholesale price inflation (WPI) staying in double-digits for 12 consecutive months, pressure on the Reserve Bank of India’s Monetary Policy Committee (RBI MPC) to hike the repo rate is very high. However, the panel will have to walk a tightrope while balancing growth-inflation dynamics and managing a steepening bond yield curve.
In an exclusive interview to Moneycontrol, IDFC FIRST Bank’s India economist Gaura Sen Gupta spoke about why the RBI will need to strike a delicate balance between dealing with the build-up of supply-side inflation pressures and protecting the ongoing growth recovery. Edited excerpts:
With CPI and WPI above the RBI’s upper tolerance band, will inflation overshoot the RBI’s forecasts for FY23?
We expect CPI inflation to overshoot the RBI’s forecast in FY23. We are currently working with CPI inflation averaging at 6 percent in FY23 versus the RBI’s estimate of 5.7 percent. Our inflation trajectory indicates that CPI inflation will average above 6 percent for three consecutive quarters (Q4 of FY22 to Q2 of FY23). We have factored in sticky core CPI inflation (excluding tobacco), which is expected to average at 6.1 percent in FY23. This builds in continued pass through of input cost pressures by producers to retail prices as output gap narrows.
WPI inflation captures more fully the input cost pressures faced by producers as the index puts greater weight on commodities. There is a strong correlation of 70 percent between core CPI goods inflation and non-food manufacturing WPI inflation, supporting our expectation of pass through of input cost pressures by producers.
Is the RBI still downplaying the inflation threat given that oil prices are showing no signs of cooling below $100 per barrel?
The RBI’s estimate of crude oil at $100 per barrel is realistic given that we expect crude oil supply to improve and demand for crude to weaken given the slowdown in China. On the supply side, we are seeing higher production from the United States and OPEC. Global monetary policy tightening in response to the surge in inflation pressures will also have a dampening impact on demand.
The current price of crude also factors in geopolitical risks from the Russia-Ukraine crisis, which remains highly fluid. A possible de-escalation in tensions could see moderation in crude oil prices. That said, global crude oil inventories remain low, so crude oil prices will stay elevated in the near term.
How feasible is it for monetary policy to address supply-driven inflation?
This is the key question facing global central banks today: Is monetary policy, which impacts demand, an effective tool to deal with a supply-side issue? While the inflation situation in the US is more adverse, with CPI inflation at 8.5 percent against the Federal Reserve’s target of 2 percent, the required monetary response is clearer. This is because inflation pressures in the US are a combination of supply and demand factors. The demand-pull side is driven by an extremely tight labour market, which has been described by the US Fed as “tight to an unhealthy level.” In such a situation, tighter monetary policy is effective as it will dampen the demand pressures.
In the case of India, RBI will need to strike a delicate balance between dealing with the build-up of supply-side inflation pressures and protecting the ongoing growth recovery. Labour market conditions in India reflect the uneven nature of growth recovery, with the formal sector doing much better than the informal sector. Urban wage growth, which is proxied by staff costs of listed companies, is growing in real terms after accounting for inflation. However, nominal rural wage growth remains weak, averaging at 4.1 percent in FY22 (till February) v/s rural CPI inflation of 5.2 percent over the same period. Hence, while the RBI was correct in starting the policy normalisation process, the pace will need to be gradual, given the uneven nature of the recovery.
How severe is the threat of generalised inflation with respect to the bottom of the pyramid?
In Q4 of FY22, rural areas are seeing higher levels of CPI inflation than urban. In the March 2022 CPI print, the gap has widened, with rural inflation at 7.7 percent and urban inflation at 6.1 percent. This was led by higher food and core inflation in rural areas. Whether this turns into generalised price pressure is not yet clear as there is labour market slack in rural areas. This is reflected in the NREGA data, where demand for employment, (though lower than the pandemic peak) remains higher than pre-pandemic levels.
However, the formal sector has seen a much stronger recovery with companies remaining functional during the lockdowns. The expansion of the formal sector is also indicated by the strong pick-up in electronic payments post the pandemic and buoyancy in tax collections. The latest RBI OBICUS survey shows improvement in manufacturing sector capacity utilisation to 72.4 percent in Q3 of FY22 from 68.3 percent in Q2.
What are your expectations on the RBI’s interest rate hike cycle and the change in policy stance?
The RBI’s April policy guidance indicated a clear shift in policy by prioritising inflation (price stability) over growth. Policy focus is on the withdrawal of accommodation, starting with the normalisation of the liquidity adjustment facility (LAF) corridor in April. The next step is likely to be a 25 basis points repo rate hike in the June policy along with a change in stance to neutral.
The upside risk to inflation has clearly firmed up with the surge in global fuel and commodity prices. Our inflation model indicates that the April 2022 CPI inflation print could be between 7 percent and 7.2 percent, depending on how food prices evolve. The peak impact of the rise in retail fuel prices will be captured in the April CPI print. Hence, we expect the policy stance to shift to neutral in the June meeting and repo rate hikes to start.
Given that the growth recovery in India is showing signs of weakness, the pace of policy normalisation will need to remain moderate. This is also reflected by the RBI’s sharp downward revision in FY23 GDP growth estimate to 7.2 percent from 7.8 percent in the February policy. For the full calendar year 2022, we expect three to four repo rate hikes of 25 bps each.
Is the policy stance losing relevance, as argued by MPC member Jayanth Varma?
No, the policy stance remains relevant and has done its role in signalling a shift in policy priorities. The current stance indicates two changes — 1) inflation is prioritised over growth, and 2) focus is now on removal of accommodation. The April policy stance provides this flexibility to RBI to withdraw accommodation while remaining accommodative.
Has the RBI largely fallen behind the US Federal Reserve when it comes to policy normalisation?
No, we disagree. The growth-inflation outlook in the US and India differ and policy response needs to be tailored accordingly. In the US, there has been substantial fiscal and monetary policy support in response to the pandemic. The inflation dynamics also differ with a combination of demand and supply-side factors prevailing in the US. The labour market in the US is extremely tight, with the unemployment rate at 3.6 percent, which is lower than the neutral rate. In India, inflation pressures remain largely supply-side led, with the presence of negative output gap and uneven recovery in the labour market.
In terms of future policy path, the Fed will be tightening more aggressively with seven policy rate hikes in 2022. Quantitative tightening, which is expected to start in May 2022, will also be more aggressive. The more aggressive pace of policy tightening by the Fed is required to get demand conditions back in alignment with supply.
What is your assessment of the RBI’s growth forecasts for FY23? How much of the risk from the Russia-Ukraine war has been priced in?
The risk from the Russia-Ukraine war will be more indirect as India’s trade linkages are limited. In FY21, Russia accounted for 1.4 percent share in India’s imports and 0.9 percent share in India’s exports. Moreover, Russia accounts for only 1.6 percent of India’s crude petroleum imports. The impact will be felt more via indirect channels such as elevated crude oil and commodity prices. The RBI’s estimate of FY23 GDP growth at 7.2 percent incorporates not only elevated crude oil prices but also takes into account weaker external demand, tightening of global financial conditions and persistent supply-side disruptions.
Compared to RBI, our GDP estimate is on the higher side at 7.8 percent. While we do see a downside risk to our estimate, we still expect it to be higher than 7.2 percent.
With bond yields hardening, what steps should the RBI take to soothe sentiment?
The only way to soothe market sentiment will be via restarting open market operations (OMOs). However, the shift of monetary policy focus towards withdrawing accommodation indicates that restarting of OMO purchases will only be done reactively. Indeed, the RBI used auctions to signal its discomfort at the rising yields by devolving part of the 10-year G-Sec issuance.
The approach towards liquidity normalisation will be gradual, with the RBI indicating withdrawal of liquidity surplus spread over a multi-year timeframe. Hence, any OMO intervention would need to be sterilised. One option is using USD-INR sell-buy swaps to reduce durable INR liquidity, creating space to conduct OMO purchases. The other option is liquidity-neutral Operation Twists, where the RBI buys long-end bonds and sells an equal amount of short-term paper. This will depend on the quantum of short-term paper the RBI is holding on its balance sheet.
Where do you see the 10-year bond yield by March-end?The combination of rising global yields and higher supply of G-Secs will maintain the upward pressure on yields. Moreover, the shift in monetary policy focus towards withdrawing accommodation indicates that the quantum of OMO purchases by RBI could be lower. Hence, we expect 10-year G-Sec yield to rise to 7.5 percent to 8.0 percent in FY23. We expect one-year USD-INR range between 75.50 and 78.