Monetary Policy: RBI Chooses Domestic Considerations Over Global Catalysts
Signalling that "one size doesn't fit all" when it comes to the rate path, the Reserve Bank of India and the Monetary Policy Committee made it categorically clear that domestic considerations will outweigh global catalysts when it comes to changing the policy direction.
To that extent, the announcements and guidance delinked the accommodative stance on policy from liquidity absorption, implying that policymakers remain circumspect about growth prospects while inflation risks are under watch. Hence, even as they extend their dovish bias, liquidity calibration can carry on in a "calibrated and undisruptive" manner, preventing markets from frontloading rate hike expectations.
The broad thrust of the policy decision at the October policy review was along our expectations, a) cut in inflation forecasts, b) expansion in the variable rate reverse repo size, c) status quo on all key parameters. While we had expected the scale of G-SAP to be cut and made liquidity neutral through operation twists or open market operations, the decision to cease purchases comes as a surprise.
This was likely driven by two reasons.
Firstly, tolerance for a gradual rise in yields as a consequence of macro triggers has lowered the need for the central bank to participate actively.
Secondly, liquidity management was being complicated by counteraction, including bond purchases.
Banks, financial institutions, and foreign investors (drawn by a likely bond inclusion into global indices) are likely to pick up part of the slack. That said, any disruptive moves are likely to attract swift action from the central bank, as yield levels are viewed as "a public good".
Coming back to growth, notwithstanding positive signs of normalisation, policymakers are still circumspect on the outlook, given existing slack. While the latter put paid to any fears that the central bank is behind the curve, inflation, in our view, still warrants attention beyond the near-term moderation that we're likely to witness between September and November.
Here global developments will also matter, particularly in light of the rally in commodity prices, including oil, coal, and metals, as well as elevated input prices via the shortage of raw materials, high logistics costs. Inflationary expectations are elevated, rising from pre-pandemic levels of 9% and likely to stay sticky above 11% this year.
Glocal Headache—Commodity Price Increases
Global crude prices have surged to three-year highs, with a break above to be at levels last seen in 2014. Following the rally in Brent prices, India’s crude benchmark is up around 60% year-to-date, rising towards $81 a barrel. After a two-month hiatus, domestic fuel retailers have resumed price increases, with the rigidity in domestic fuel taxes magnifying the net impact at the pump. The retail selling price as of Oct. 1 is more than 2x of the base price for diesel and petrol. Additionally, taxes (centre and states) are at 1.4x the petrol base price and 1.1x of diesel, based on prevailing prices in the capital.
Under the CPI basket, fuel and light have 6.8% weight, with transport and communication at 8.6%. The fuel index is up an average 11.6% YoY between April and August 21, and T&C is up 11% in the same period. The direct and indirect impact via the weightage of fuel and related products in the inflation basket implies that for every $10/barrel move in the oil prices, it results in a 30-40-basis-point change in the headline CPI, with a bigger impact on WPI inflation.
Concurrently, a shortage in coal supply is looming, with the nodal authority cautioning that more than half of the coal-fired plants had less than a week’s stock, by late September. This shortfall is driven by a combination of a reopening-driven surge in demand for power, weather-led disruptions hurting mining activity, and slower imports due to high costs (coal and logistics). For inflation, the commodity’s direct weight on the retail CPI basket is negligible and modestly higher (2.1%) in the wholesale price basket, but the indirect impact might be amplified, channelled via higher input prices through producers as well as manufacturers (aluminium smelters, cement, steel mills, etc.) and utility tariff increases if approved.
Apart from hurting the pace of production, risks of an eventual impact on discretionary purchasing power and consumption are additional concerns.
As G-10 Edges Towards Normalisation, Asia’s Resilience Will Be Put To Test
Asian local currency sovereign bonds have lots to contend with, in the second half of 2021 which will also spill over into 2022. They will find themselves caught between rising developed market yields, inflation concerns, and risks emanating from China (spanning from slowdown to the energy crisis, which might stoke price concerns). While the U.S. Federal Reserve has signalled plans to start tapering, few other major central banks have been more hawkish, including the Bank of England, Reserve Bank of New Zealand, among others.
Oil, policy normalisation expectations, lack of GSAP, and global factors should push up G-Sec yields, overshadowing fiscal positives. The generic 10-year yield has risen 25 basis points since mid-2021, while the two-year yield has stopped falling and has been rising since September. We look for the yields to shift up further by year-end, with the 10-year expected to approach 6.4% by end-2021.
Radhika Rao is Economist and Senior Vice President at DBS Bank, Singapore.
The views expressed here are those of the author and do not necessarily represent the views of BloombergQuint or its editorial team.