The off-cycle review meeting of the Monetary Policy Committee (MPC) last month clearly pivoted towards inflation over growth as a policy priority. The Reserve Bank of India's (RBI) rhetoric has firmly moved in a hawkish direction and the need to focus on withdrawal of accommodation. The normalisation of monetary policy in major advanced economies has gained pace significantly – both in terms of rate increases and unwinding of quantitative easing (QE) as well as rollout of quantitative tightening. Globally the US Fed has begun the fastest pace of tightening in decades, having already raised the policy rate by 75bp in two meetings, and is guiding for 100bp in hikes over the next two meetings.
Minutes of the last unscheduled meeting revealed uneasiness of most members on deep negative real rates. Few members opined a more nuanced and calibrated approach to rate hikes once the RBI reached its pre-Covid neutral accommodation (5.15 percent). The Governor noted that broad-based price shocks were emanating from the increase in commodity prices, with the pass through starting to become visible, especially in food prices.
The MPC is likely to increase the benchmark lending rate in its forthcoming monetary policy review as inflation shows no signs of abatement. The government's recent measures to tackle inflationary pressures are a welcome response to the need for complementary fiscal and monetary policies to manage the adverse growth-inflation mix.
Inflation concerns have aggravated with its trajectory heavily contingent upon the evolving geopolitical situation. The escalation of geopolitical tensions into war from late February 2022 has delivered a brutal blow to the world economy, which has been through multiple waves of the pandemic (in 2021), supply chain and logistics disruptions, elevated inflation and bouts of financial market turbulence. International crude oil prices remain high but volatile, posing considerable upside risks to the inflation trajectory through both direct and indirect effects. Core inflation is likely to remain elevated in the coming months.
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May policy hike announcement was to prevent large deviations in real rates, which cause risks of overheating or of a slowdown; as inflation risk has become more pronounced both in terms of magnitude and in terms of persistence. Members noted that inflation was becoming generalised and policy action was needed to prevent second-round effects from materialising.
Retail inflation surged to 7.79 percent in April 2022, touching an 8-year high mainly because of surging food, commodity prices, including fuel, due to the ongoing Russia-Ukraine war. The wholesale price-based inflation has remained in double digits for 13 months and touched a record high of 15.08 percent in April. Rising input costs have become the primary cause for concern for the economy.
Moreover, producers are unable to pass on their rising costs to consumers for the fear of adversely impacting the nascent recovery in demand. This is reflected in the consistently wide gap between CPI and WPI inflation. Price increases are likely to stay elevated (till calendar year end) and spillovers from global food shortages and supply chain issues could translate into another round of price pressures; warranting resolute and calibrated steps to anchor inflation expectations and contain second round effects. Some upward revision to inflation forecast would be warranted in the June meeting.
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To curb inflationary pressures, the central government recently announced - excise duty cuts of Rs 8 per litre for petrol and Rs 6 per litre for diesel, LPG subsidy of Rs 200 per cylinder, additional expenditure of Rs 1.1 trillion for fertilizer subsidy, wheat export ban and customs duty cuts for coking coal, naptha, ferro-nickel, propylene oxide, etc. and export duty hikes for select steel products. These countercyclical government measures have clearly provided room for the MPC to avoid disruptive (aggressive) tightening. It is important that fiscal and monetary policies move in tandem to bring inflation within targeted levels and provide support to economic growth.
The GDP print for the last quarter of FY22 came in at 4.1 percent (higher than consensus expectation of 3.9 percent), which marked the continuation of slowing growth. The quarter was affected by few headwinds – surging crude prices and continual supply-chain constraints as aftermaths of the pandemic; Q4 was also characterized by Omicron-driven restrictions in January, followed by geopolitical conflicts in Russia and Ukraine which worsened the supply-chain woes and exacerbated inflation. The high frequency data for India for April 2022 and May 2022 suggests that the global headwinds had not dented volume growth to a great extent. Nevertheless, business margins are likely to be compressed, amidst an incomplete pass-through of input price pressures, while higher inflation would constrain demand growth.
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The forecast of a normal southwest monsoon brightens the prospects for kharif production supporting rural economy. Investment activity should get an uplift from robust government capex, improving capacity utilisation, stronger corporate balance sheets and congenial financial conditions. Consumption demand, however, is yet to see a durable pick-up in the domestic economy. Rural demand recovery has also been weak. High food and fuel inflation pressure may further adversely impact consumption spending. With domestic demand remaining feeble and with higher inflation dampening the purchasing power, the RBI may not want to raise rates too aggressively too soon.
We do not expect CRR hike in upcoming meeting. High Government borrowing has ruled out the possibility of OMO sale, thus CRR increase seemed as the possible non-disruptive option of absorbing the durable liquidity. The RBI will attempt to normalise liquidity conditions over a multi-year time cycle, remove the overhang of liquidity in the system and move to a situation where there is adequate credit available in the system to meet the productive requirements of the economy and to support the credit offtake.
The RBI is likely to follow a nuanced and calibrated approach to rate hikes once its pre-Covid neutral accommodation of 5.15 percent is reached. We expect 40bps rate hike in the upcoming policy meet and expect the RBI raising policy rates to reach 5.15 percent by August/October. The RBI could also raise the inflation forecast and cut the FY23 GDP estimates.
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