Inflation vs growth: Monetary policy is at a crossroads

The sluggishness in economic growth is likely to affect all major economies to varying degrees. (Photo: Shutterstock)

Recent market movements and the broad discussions in the marketplace centre around two clear probabilities. The first is around the potential for inflation to come down further. The second is the heightened fear of an economic slowdown. The latter is in fact accentuated by the lingering sparks of the banking issues that surfaced about a month back. It was not a liquidity issue but some deficiencies in managing the asset-liability mix against the emerging scenario of high rates and relatively lower liquidity.

As far as the former is concerned, it can be inferred from the data available as of now, that the trend in inflation is gradually moderating. But it may not come down too fast. The gains may be limited. This is caused by the summer, which is unusually warm and unseasonal rains too. This may affect the crop of fruits and vegetables as also some essential farm products.

The El Nino effect could also come into play as soon as the fag end of the summer. Housing costs and rentals have skyrocketed, and they may sustain for a longer time due to the massive unfulfilled demand that is still available in the space. Demand may also get accentuated as many expect mortgage rates to rise, so they end the wait and buy the asset before the rates may rise further. These expectations add fuel to the fire.

The latter factor, which is the fear of a slowdown, is already confirmed by the expected growth numbers published by the IMF and several other multilateral institutions. The sluggishness in economic growth is likely to affect all major economies to varying degrees, and India could be an exception displaying a normal growth rate. Given these two macro undercurrents, there is already a pause in the rate hike cycle in India. The pause may be prolonged for more time if inflation numbers from time to time fall within the RBI target range. The pause may be followed by other countries too, especially the US and Europe. The pause could be longer than expected as it is difficult to move into a rate hike mode after a pause but only if the inflation numbers are hard.

Fall in Bond Yields

The pause also favours a fall in the market yields if money market conditions are normal. However, in conditions like an inverted yield curve, it may take time for yields to adjust to the changing views on the trajectory of interest rates. The pause by the RBI and the falling inflation levels may prompt yields to decline but one needs to take cognizance of the fact that the 10-year benchmark yield which is hovering at around 7.10 percent is dangerously close to the overnight rate of 6.75 percent, and that the one-year certificate of deposit (CD) and commercial paper (CP) rates are at 7.50-7.80 percent. This may warrant either a retracement of the 10-year yield to higher levels, or the short-end rates may have to trend lower.

But the issues in the domestic market are not in the official policy or the inflation levels, but more in the liquidity conditions which are influenced more by the massive government borrowing programme. While the borrowing so far has not caused any disruption, the supply at the primary auctions may be more important in the larger scheme of things. Short to medium term portfolios with portfolio yields close to 8 percent, and a maturity profile of 2-3 years would make better investment sense.

Joseph Thomas is Head of Research, Emkay Wealth Management. Views are personal, and do not represent the stand of this publication.