MC Interview: RBI must make stance neutral once 4% inflation is visible, says HSBC’s Bhandari

The Reserve Bank of India’s monetary policy stance surprised markets on Wednesday with its hawkish tone even though the increase in the repo rate was a relatively benign 35 basis points (bps) after back-to-back 50 bps hikes earlier. But Pranjul Bhandari, chief India economist at HSBC, believes that the central bank struck the right note.

“If in the next year you are not able to see inflation at 4 percent and then you change your stance to neutral, you end up giving a sense to the market that you were not serious about the 4 percent target in the first place,” said Bhandari in an exclusive interaction with Moneycontrol.

Bhandari believes that the stubbornness in core inflation is more challenging now for the RBI as increased formalisation has raised the pricing power of large firms. Relief of food inflation and some deft supply management by the government could ease the RBI’s burden.

Growth will slow in FY24 to 5.7 percent with exports and private consumption moderating. The story of private capex revival should be viewed with caution, she said. Edited excerpts:

Yesterday’s rather hawkish stance and commentary from the RBI, has it changed your expectations or you are still sticking to the 6.5 percent terminal repo rate?

I am sticking to the 6.5 percent forecast for the terminal repo rate. The policy meeting outcome was very much in line with our expectations. We had expected that they will do a 35 bps rate hike and dial down on the size of the hikes. But to compensate for that, they will sound fairly hawkish on the commentary side. That is important because the RBI wants to make sure that the transmission continues and does not reverse.

This is the right way when you don’t want to hike but also ensure that the transmission continues.

How do you read the RBI’s statement on core inflation? Do you get a sense that they have brought this just to drive home the point of their ultimate goal of 4% inflation?

There was a lot of emphasis on core this time and I think there are two reasons for this. Food inflation has fallen a lot since October, about 80 percent of the food basket has started to see some moderation in momentum.

I think in the next couple of months the year-on-year numbers will also reflect this. The divergence between food and core inflation will become amplified. So the RBI is picking up on that and laying it out before this happens. Our sense is that food inflation could fall to about 4 percent but core inflation could remain well north of 6 percent. The second reason is that the ultimate aim was to dial down on the rate hikes but continue to sound hawkish. This is the right way to do it. I think they are seeing that core is sticking out, it has remained elevated. So they are bringing it to the table.

When should they move to a neutral stance according to you?

In my view, the RBI should wait before changing its stance. They always give a one-year-ahead inflation forecast and as long as the one-year-ahead does not show 4 percent, I think they should continue with the current stance. If in the next year you are not able to see inflation at 4 percent and then you change your stance to neutral, you end up giving a sense to the market that you were not serious about the 4 percent target in the first place.

So my sense is that the day we see the one-year-ahead forecast at 4 percent, that day we can see a neutral stance. The stance will remain unchanged in February. We should see the MPR (monetary policy report) in April to get a sense of the RBI’s forecast.

I’m bringing in the external sector element here because a lot of inflation have been driven by imports, mainly crude. Will crude give some relief or is the jury still out on it? The RBI assumes a $100 per barrel price, are they overestimating at that level?

This part of inflation is extremely volatile and unpredictable. Crude prices are difficult to predict because there are many moving parts to it. On the one hand, you have growth impulses around the world slowing but on the other hand, when China comes out of lockdowns and starts growing, we have to see where it takes oil prices.

The RBI’s $100 per barrel does sound a little high because the current spot prices are lower but to be honest, it is very hard to get a strong handle on where oil prices will be. The RBI is being conservative but I would not change any forecasts on oil alone.

How do you see the WPI/CPI wedge evolving? A lot of pass-through has happened and is happening even as wholesale inflation seems to be cooling off a bit now.

There will be base effects at play here too since WPI is coming off from high levels. The main question to ask is, why is inflation in India sticky? Even before global inflation took off, our inflation was high and sticky. In a way, our inflation accelerated even before global inflation took off. There have been too many back-to-back shocks. It all started with the lockdowns in 2020.

Many informal firms shut shop and because these were dealing with essentials such as food, clothing, etc, there was a supply disruption. This led to core inflation springing up suddenly. It is mainly because of the structure of the economy since we have many informal small firms operating. As the economy was getting out of this pandemic by 2021, this year we had this large commodity price shock and that shock is still in the system.

First, it has increased WPI and then CPI. Then it raised rural inflation because rural has more volatile components of oil such as bulk diesel and ATF (aviation turbine fuel) that are not controlled by the state. But as rural is coming off, while urban is rising.

First, it hit goods inflation, and now services inflation is coming up. There is yet another shock that is playing out which is climate change-related shock—the heat wave of March, volatile rains during the monsoon, and untimely rains in October. All of this has played havoc with food inflation and expectations. All of this has implications for core inflation too.

At some point, if growth begins to slow next year, we will get some relief on core inflation provided no big shocks come our way.

Next year we will have headline inflation below 6 percent. I think coming under 6 percent will be visible from the start of the next year but 4 percent is still very far away.

How serious should the RBI be on the 4 percent inflation target?

The growth-inflation trade-off becomes very clear when we talk about core inflation. But there is another big player, which is food inflation. It is 46 percent of the CPI basket. Disinflation in food does not have to come at the cost of slower growth. It is the outcome of climate events which we have no control over but also supply-side management which is in the hands of the government.

I think this government has been nimble on the supply side. They have been very quick in selling from stocks or buying, quick imports and exports from other markets. I think this 46 percent of the basket is going to be controlled well by the government. It will be controlled even better next year because it is a pre-election year.

I think a lot of solace comes from this part of the basket. The remaining then is the core inflation, about 45 percent of the basket. Here, there will be a trade-off. If food inflation is managed, then the RBI’s job becomes that much easier. In my forecasts too, I see disinflation in FY24 and much of this is coming from a favourable base effect and food inflation coming down.

I think there are a lot of moving parts in the core. The RBI cannot control all of it with its policy. One big part is the structure of the industry. The fact is that large firms have gotten larger during the pandemic period and they have pricing power. So prices are hiked but not brought down quickly if there is pricing power.

The persistence in core is from this structure of the industry and I think this is getting more and more ingrained in the system because of the formalisation that has happened. Therefore, the reliance on food inflation will be more in order to engineer a disinflation.

How optimistic are you about private consumption resilience when you look at the growth numbers?

I think private consumption has had a decent run in the last couple of years because of how pent-up demand, particularly for services, has played out and is still playing out. If overall global growth is going to weaken in the next year as is our forecast and we see export volumes slowing in many parts of the world, it will hurt incomes here too.

India has really ramped up exports in the past couple of years and if this slows, we could see incomes in industries focused on exports fall. This could hurt consumption. While consumption has been decent, along with other sectors it would also start to slow next year.

You have pointed out that capex is largely a replacement. How do you view this private capex revival?

When you look at a lot of capex indicators such as cement, steel, and project goods, they all are doing very well. Fast-moving indicators also show capex is strong. The obvious answer could be the public sector but state governments have dialed down on capex even when the Centre has ramped up.

Even PSU capex has been lackluster. So when you add all this, there isn’t a great push towards capex coming. That brings us to private sector capex. Here we found that all indicators of a new investment cycle have not really risen dramatically. There is no real money on the ground. The private sector capex is not coming from new intentions, so it is mostly replacement.

If we look at gross investments and net investments, the gap is depreciation. This number is on an uptrend right now. This time it is far more amplified since for two or three years the regular annual replacement capex did not happen because of the pandemic. This is what is driving up steel, cement, and other indicators.

So what does this mean for growth? Should we rein in our optimism?

Well, we should not get too pessimistic. The stage is set for a new capex cycle to start. Our balance sheets are cleaner than they were last decade. There is a lot of excitement about India’s medium-term prospects. We will see capex on the back of that pick-up.

My point is this has not happened yet. We need balance sheet strength, and macroeconomic certainty for capex to thrive. We have good balance sheet strength but macroeconomic certainty eludes. There is volatility in commodity prices, and difficulties in forecasting inflation and policy action. We have to wait for this storm out, we can see a new cycle picking up.

Going by global headwinds, will FY24 growth be a domestic story?

Since the pandemic, the economy has been driven by exports. That has been the reality so far. We are seeing export volumes beginning to fall now and my sense is that on the margin the reliance on domestic growth to keep GDP growth high will increase next year.

On many fronts, in exports and private consumption, there will be some slowdown next which we will have to live with. Our forecast for FY24 GDP growth is 5.7 percent. From FY24 onwards, we would have no pandemic-related base effect and noise. Therefore, this 5.7 percent is significant because in my view potential growth right now is about 6 percent. So we would be running below potential.