The sense of recovery that had started to set in by March has been met by the second coronavirus wave in India. As the Reserve Bank of India (RBI) monetary policy committee (MPC) deliberates on its first policy decision for FY2022, it will experience something similar to what it did in March-April 2020.
With the benefit of the policy measures already in place along with administrative and medical infrastructure gaps filled up over the year, the central bank now has a playbook to turn to though challenges remain.
The questions which will be at the forefront for the MPC are: (1) have India’s growth prospects dimmed with the ongoing second wave of the pandemic, (2) have inflation risks increased, especially, if (a) supply issues crop up again and (b) headline inflation tends to converge towards the high core inflation, and (3) with liquidity adequately in surplus, given the growth-inflation dynamics, how should policy normalisation play out?
For the April policy, policy normalisation will remain in the shadows. Wait-and-watch mode will continue with adequate caution on downside risks to growth and upside risks to inflation.
During the second wave, localised lockdowns will be the norm in the near term. While governments will try to protect activities, the nascent economic recovery will possibly get further drawn out, especially for services.
The RBI will likely maintain its FY2022 GDP estimate at 10.5 percent and watch the impact of the second wave on economic activity. Further, given the impact of food subsidy in FY2021-22, the gross value added growth needs to be more closely watched to gauge the "real" growth outturn.
Localised lockdowns are unlikely to dent the growth prospects significantly but risks remain skewed towards the downside. Compared to the RBI projections in February, headline retail inflation will be slightly lower but well above its comfort zone of 4 percent.
Headline inflation is likely to be in the 5-6 percent range for the year. However, the upside risks of inflation will continue and the RBI will be cautious as risks of supply disruptions will marginally increase with the second wave.
The increase in raw material price is starting to show up in output prices as in the auto sector. As the vaccination drive progresses, service inflation will start coming back.
Core inflation pressure has been building up and has become more broad-based over the last few months. Continued upside risks to core inflation from supply disruptions and input prices need to be watched.
Core inflation is likely to remain in the 5.5-6.5 percent range for the most part of the year. The larger problem for the RBI will be managing the impossible trinity. With global monetary policy remaining loose, India could continue to see capital inflows.
A large government borrowing would also need large RBI support to keep yields under check. If inflation risks were to intensify, the RBI’s playbook will see more challenges.
Keeping interest rates in check is important to ensure recovery takes roots but macro-prudential considerations, sooner rather than later, would require a gradual normalisation of short-term rates through the liquidity channel.
Rising US yields and higher crude prices will remain significant exogenous risks for financial markets but given the challenges, the RBI will prefer to tackle them as they come.
For now, the RBI needs to support growth and the government needs to rapidly step up the vaccination drive to minimise risks to the real economy. The RBI MPC is likely to keep repo rate unchanged and maintain an accommodative stance over the near term.
(The author is Senior Economist in Kotak Institutional Equities)
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