Inflation worries: Will RBI bite rate-hike bullet and puncture market sentiment?

India's retail inflation prints remained above 6 percent for the second consecutive month, fanning concerns that elevated prices may force the Reserve Bank of India (RBI) to rethink its current stance when it meets for the monetary policy review in August.

June is the second month in a row when headline retail inflation remained above RBI's monetary policy committee's inflation target range of 4  percent, plus or minus 2 percent.

Consumer Price Index-based inflation (CPI), or the retail inflation, for June rose 6.26 percent, as food prices hardened and transportation costs rose due to pricier petrol and diesel. The June print is, however, a tad lower than 6.3 percent in May, which was the highest in six months.

Policy normalisation coming?

It is unlikely that the RBI will go for a rate hike anytime soon as the economic growth is still picking pace and the risk of a third wave of COVID-19 is very real.

"The RBI monetary policy committee (MPC) is likely to stay focused on growth with an eye on the risks of a third wave, but members are likely to express discomfort on the recent bout of sticky inflation, in the absence of supply-side corrective steps (i.e. fuel excise cuts)," said Radhika Rao, Economist at DBS Group Research.

Instead of tapering its liquidity infusion measures, the central bank may rely on the government’s supply-side measures, including increased imports and measures to prevent hoarding, to keep the inflation under control.

Rahul Bajoria, Chief India Economist, Barclays India, expects core CPI to remain sticky in the coming months and decline modestly over 6-12 months.

"India’s inflation is being driven by non-domestic factors, limiting policy options and squeezing profit margins. As demand improves following India’s second wave of COVID-19 infections, we believe firms will increase prices in order to sustain higher volumes. As a result, even if imported price pressures recede, margin normalisation may keep CPI inflation elevated and sticky," said Bajoria.

"Given the predominantly supply-side driven inflation pressures, we expect the central bank to maintain an accommodative posture and lean on the government’s supply-side measures to rein in price pressures."

Also read: Factor in inflation, include equity while investing your retirement kitty

Most market analysts expect the RBI to keep the rates steady for at least 2021 though some see the possibility of a hike in early 2022.

"We believe that the RBI will stay on hold for this year though we may see some rate hikes next year. We do not think that the RBI will be in a hurry to raise rates as India is just coming out of a second Covid wave and we need an easy monetary policy to nurture growth for some more time," said Jyoti Roy, DVP, Equity Strategist, Angel Broking.

Roy expects normalisation of monetary policy by next year, once growth normalises to pre-Covid levels. The inflation spike is transient and should subside to a large extent by early 2022 as supply chains normalise, which should allow the US Fed and the RBI to maintain their accommodative stance for some more time, Roy said.

Upasna Bhardwaj, Senior Economist at Kotak Mahindra Bank, expects policy normalisation to begin at the end of the year.

"We continue to expect the MPC to retain its current policy guidance in the August policy in favour of growth. However, towards the end of the year gradual policy normalisation will be underway," said Bhardwaj.

While the headline inflation remains elevated above MPC’s upper threshold of 6 percent, June print suggests that inflation may have peaked and the trajectory in Q3FY22 will moderate towards an average of 4.7 percent, said Kotak Securities.

"We expect RBI to continue to maintain a pro-growth bias in the August policy focus given that a large part of the increase still remains supply-driven and, hence, transitory in nature," Kotak said.

However, the brokerage believes as economic activity begins to normalise with progress in vaccination, RBI’s room to ignore the inflationary risks, as well as a closing of the negative output gap, will be restricted, prompting gradual monetary policy normalization from October, although much will depend on the evolution of the pandemic, vaccination, and data.

The brokerage firm expects headline CPI inflation to average 5.3 percent in FY2022.

Also read: Exclusive Interview | COVID-19 behind us, inflation will have big influence on how markets behave: Aswath Damodaran

Impact on market sentiment

Nikhil Gupta, Chief Economist at Motilal Oswal Financial Services said the headline inflation had peaked.

"Overall, it appears that headline inflation has peaked out, which will provide some relief to the markets that RBI will stay on course for a longer time. We don't see any rate hike in FY22," Gupta said.

The key factors for the market to focus on are the pace of economic recovery, quarterly earnings and rapid vaccination.

Enough green shoots such as successful vaccination drive, comfortable policy support and buoyant sentiment have emerged globally that point towards sustained economic recovery, brokerage firm Edelweiss Broking said.

"While India is currently lagging developed markets, the return of global growth and private capex, structural reforms and continued pro-cyclical policy support bodes well for the economic recovery ahead," said Edelweiss Broking.

While downside risks from the third wave, subdued credit and general sense of risk aversion remain, India’s growth story is expected to pick up significantly. In fact, Nifty FY22 earnings growth estimate stands at an impressive 42 percent, the brokerage firm said.

The market expects the RBI to give a clear hint before it begins policy normalistion. The market seems to believe that the central bank will not raise rates in FY22, experts said.

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