Inflation Spike May Push MPC Towards ‘Policy Normalisation’ By Year-End
The Reserve Bank of India has spent the past year firefighting the economic crisis brought on by the Covid-19 pandemic. In doing so, growth has been the single-point focus for the central bank. Interest rates were cut, the financial system was flooded with money, incentives were given to channel that money to those that need it, support was provided to ensure the government can borrow comfortably to spend.
Along with the rest of the world, this was the Indian central bank's 'whatever it takes' moment. Reiterating that focus on repairing growth, RBI Governor Shaktikanta Das, earlier this month, said the central bank isn't even thinking of "normalisation" at the moment.
India's Monetary Policy Committee, entrusted with the single task of keeping retail inflation within the band of 4(+/-2)% using a single policy tool of the repo rate, has mostly played along. While its role had been more limited amid the Covid crisis, the committee has not muddied the waters for the central bank as it tried to fight the Covid crisis with its wider policy toolkit.
This gentle balance may now be disrupted as retail inflation moves above the tolerance band of 6%. To be sure, the uncomfortably high May inflation reading may yet prove to be an aberration. The month may have seen one-off price rises due to lockdowns imposed across a number of states. However, should higher inflation persist, the Monetary Policy Committee and the central bank will have tough choices to make.
"To be honest, the May CPI inflation numbers look scary," wrote Kaushik Das, chief India economist at Deutsche Bank. "While this may well be a one-off impact, it is going to increase the 12-month ahead CPI trajectory and bring it dangerously close to the upper threshold limit of the 6% inflation targeting band," he said.
Deutsche Bank has upped its average inflation forecast for FY22 to 5.8%, while flagging off a risk that it could move even higher to breach the 6% threshold.
The MPC forecasts inflation at 5.1% during FY22. While this is within the comfort band of 2-6%, it is higher than the 4% target set under the Monetary Policy Agreement.
Das said the higher-than-expected inflation readings may start to prompt a subtle shift in priorities.
"We think the MPC members will start according more importance to inflation from August policy onward," he wrote. There won't be any sudden U-turn but the need to manage inflation risks may start featuring more in the MPC's communication.
With a slight pivot expected from August, as far as forward guidance is concerned, we think the MPC will look to get back to the path of ‘normalising’ the prevailing extraordinary monetary accommodation from October-December 2021 onwards.Kaushik Das, Chief India Economist, Deutsche Bank
Nomura economists Sonal Varma and Aurodeep Nandi have a similar view.
"The upside surprise in May CPI will throw a spanner in the MPC’s growth priority stance," they wrote.
Unlike in April, the MPC will no longer be able to dismiss the rise in inflation as statistical. When the committee meets next in August, it may choose to remain in "wait and watch" mode. But by October, it may be forced to at least start signaling normalisation ahead. This, according to Varma and Nandi, will pave the way for interest rate hikes in 2022.
By the October MPC meeting, there will be sufficient clarity on both the growth damage and inflation persistence. Given our view that the growth impact of the second wave will be less than the RBI’s projection and our view of elevated inflationary pressures, we expect the theme of policy normalisation to begin in Q4. We expect a reverse repo rate hike in Q4, and a total of 75 basis points in repo rate hikes in 2022.Sonal Varma & Aurodeep Nandi, Economists, Nomura
Sajjid Chinoy, chief India economist at JP Morgan said that while one inflation print will not induce the RBI to completely reverse course, it will underscore that inflation risks continue to mount on account of a reflationary global environment intersecting with India’s economic re-opening.
Following the sharp rise in May inflation, the next three year-on-year inflation prints are expected to remain close to 6%, the upper bound of the RBI’s inflation corridor, Chinoy said.
The impact of this, we believe, will first be seen on liquidity with the RBI likely to become more cautious in injecting more liquidity to the banking system and simultaneously re-commencing use of the Variable Rate Reverse Repo (VRR) auctions – introduced in January – as a tool to mop-up liquidity before taking stock at the August policy review.Sajjid Chinoy, Chief India Economist, JPMorgan
Gaura Sen Gupta, economist at IDFC First Bank Ltd., sees it slightly differently. Central banks world over have become more tolerant of inflation and the RBI will be no different.
"...while today’s inflation print might be unwelcomed, it’s unlikely to change RBI’s policy course as growth conditions remain weak," he wrote.
Sen Gupta writes that the low levels of vaccination coverage imply that the growth recovery remains vulnerable to subsequent Covid-19 waves. Hence, he expects the RBI to look through the current rise in inflation as transient. The central bank will also likely continue to differentiate between demand-driven inflation and supply-driven inflation. In a weak economy, pressure from the former is limited.
"Consequently, we expect monetary policy to remain growth supportive with RBI keeping repo rate unchanged in FY22," he wrote.
The Covid-19 pandemic has changed policy response function globally with governments pursuing super expansionary fiscal policies and central banks becoming more tolerant of higher inflation. The post pandemic world is likely to be characterised by higher levels of inflation, initially driven by supply side disruptions and subsequently sustained by demand-pull as pace of vaccinations pick-up.Gaura Sen Gupta, Economist, IDFC First Bank