RBI Monetary Policy: Three Questions On Mapping The Turn

→ India is in an uneasy spot with accelerating inflation and an incomplete growth recovery; the RBI is likely to prepare the markets for future rate increases at its April meeting.

Will the Reserve Bank of India turn at the April 8 release of the decisions of this week’s MPC meeting, signing up for tighter monetary policy? That’s the number one question being discussed in Indian financial markets these days.

Following the rapid rise in international commodity prices, there are worries that inflation will be substantially higher than what was expected just a few weeks ago. If oil averages around $100/barrel in FY23, inflation will likely average 5.5-6%, much higher than the RBI’s 4.5% forecast for the year.

Meanwhile, on the growth front, 2021 ended with GDP at 7% below the pre-pandemic trend. Even before the recovery was complete, the oil price shock of early 2022 struck and is likely to be a drag on the economy.

With both an inflation and growth problem at hand, April will not be an easy policy meeting for the RBI. Here we answer three questions on what is at stake and how the RBI will likely react.

Question 1: Why Is Inflation Elevated Amid Weak Demand?

Inflation is somewhat of a puzzle. Why has it remained elevated through the pandemic when spending has been weak? Worth recalling here that India’s inflation was high even before global inflation had begun to take off.

On the other hand, the recovery that India experienced after two lockdowns has been led to a large extent by exports. Domestic demand hasn’t been as buoyant.

There are many ways to make sense of this puzzle. One of them is by looking at the size of firms. The RBI’s database of around 2,700 firms shows that large firms have gotten larger and gained pricing power through the pandemic. They are likely to have kept prices elevated and sticky.

On the other hand, small and informal firms have lost market share and have seen a fall in profitability. Many have shut up shop through the pandemic, hurting supply. This too is likely to have contributed to inflation.

Question 2. Which Drivers Of Inflation Should Be Watched Closely?

We identify four drivers of inflation that need to be watched carefully as they could send prices even higher:

One, the phenomenon of large firms gaining pricing power and small firms being forced to shut down will likely further intensify over the next few months. Large firms have become far more energy-efficient over time and gained pricing power. As such, they are likely to weather high oil prices better than small firms over the next few months. Meanwhile, small firms seem to be going through another wave of closures.

Two, with the Omicron Covid-19 wave having passed, pent-up demand for services is likely to be elevated over the next few months and could accelerate inflation.

Three, domestic pump prices for petrol and diesel have been raised by 10-11% over the past few weeks. They now reflect global oil prices at around $100/barrel. If the latter settles at above $100/barrel and the government continues to pass it on to the private sector, inflation would trend higher than our current forecast.

Four, several forces could unhinge food prices, which make up a substantial 46% of the Consumer Price Index basket. These include rising input costs (e.g. the price of diesel and fertiliser) and soaring global wheat and edible oil prices.

Question 3. Will The RBI Turn In April?

The good news is that the right policy mix could help control inflation and limit the pain endured by smaller firms and the informal sector.

There are two policy objectives (safeguarding growth and controlling inflation) and two instruments (fiscal policy and monetary policy). An appropriate strategy, whereby fiscal policy set by the government focuses on growth and monetary policy set by the RBI focuses on inflation, could achieve an optimal outcome.

In subsequent meetings, we expect the RBI to change its stance to neutral (from accommodative), and normalise the policy corridor (by raising the reverse repo rate). This is likely to be done alongside an announcement to buy government bonds so as to ease some pressure in the bond market. We also expect two repo rate hikes of 25 basis points each by end-2022, taking the repo rate to 4.5%.

So yes, the RBI will likely eventually turn, but not sharply in April.

Pranjul Bhandari is Chief India Economist and Managing Director at HSBC.

The views expressed here are those of the author, and do not necessarily represent the views of BloombergQuint or its editorial team.