Monetary Policy Normalisation: Likely To Commence In Q4FY22
The uncertainty engendered by the second surge of Covid-19 had prompted the Monetary Policy Committee to keep the repo rate unchanged at 4.0% in its June 2021 policy review. It had also decided to maintain the accommodative stance, for as long as necessary to durably revive and sustain growth and mitigate the economic impact of the pandemic, while ensuring the CPI inflation remains within the target.
The MPC had projected the CPI inflation to average 5.1% in FY22, with risks characterised as broadly balanced. At the same time, it had pared its forecast for the real GDP expansion in FY2022 to 9.5% from the 10.5% it foresaw before the second Covid surge had taken hold.
The Inflation Trajectory
Since then, the headline CPI inflation surged from 4.23% in April 2021, to a much higher than expected 6.30% in May 2021, before easing marginally to 6.26% in June 2021. Overall, the CPI inflation averaged 5.6% in Q1 FY2022, exceeding the 5.2% forecast by the MPC.
In month-on-month terms, the CPI had hardened by an alarming 1.6% in May 2021. However, we believe this reflected the impact of supply-side issues related to the widening state-level restrictions during the second wave of Covid-19. The MoM uptick subsequently eased to 0.6% in June 2021, as the unlocking started. While demand is recovering gradually, we expect the supply side to continue to dominate the inflation outlook for a few more months.
The monsoon rainfall has been rather uneven this year. Nevertheless, its pickup over the later part of July 2021 has helped Kharif sowing to gather pace. The gap with last year’s healthy acreage has eased to a modest 4.7% for the week ended July 30, 2021, with more than three-quarters of last year’s area having been sown.
Flooding in parts of the country is likely to have damaged crops and would dull yields. Nevertheless, changes related to customs duty for pulses and oilseeds are expected to dampen food inflation to an extent going forward.
We are cautiously optimistic that a favourable base effect will soften the headline CPI inflation print for July 2021 below 6.0%.
In our view, the calendar year 2021 CPI inflation peak is likely to be behind us.
Nevertheless, we expect the CPI inflation to average 5.5-5.7% in FY2022, uncomfortably close to the upper end of the MPC’s medium-term target range of 2-6%.
Uncertain Growth Outlook
Information on the high-frequency indicators for July 2021 has started trickling in, with data now available for electricity demand, fuel consumption, and Coal India’s output for the full month, and for vehicle registrations and generation of GST e-way bills for a significant part of July 2021. Expectedly, the broad sequential uptrend continued, with the further unlocking at the state level. Encouragingly, several indicators rose above the respective April 2021 levels. However, the majority continued to trail the robust Feb-March 2021 performance, indicating that the recovery is still incomplete.
Moreover, uncertainty persists given the emergence of the Delta Plus variant of Covid-19. As of now, we expect the Indian real GDP to expand by 8.5% in FY2022, with an upside of 9.5% predicated on accelerated vaccine coverage.
Given the uncertain growth outlook, we expect the MPC to maintain a status quo on the rates and stance in the next two policy reviews, with a reiteration of the intention to support economic activity. However, an upward revision in the Committee’s CPI inflation forecast is quite likely in the upcoming August 2021 review.
Room To Cut Fuel Taxes
In the last three Monetary Policy reviews (February, April, and June 2021), the MPC highlighted the inflationary pressures created by the higher cesses and VAT rates announced on auto fuels by the centre and the state governments last year, and the need to unwind the same to ease the cost-push pressures. Another such nudge appears quite likely in the upcoming review, with the excise duty collections of the Government of India having expanded by a considerable 92.1% in Q1FY22, benefitting from the cesses imposed on fuels.
This suggests that there is some space to reduce the cesses on petrol and diesel, which will both boost the consumption sentiment and ease inflationary pressures. This would allow monetary policy normalisation to be postponed, in a bid to continue to support economic activity in an uncertain growth environment.
A sharp jump in tax and non-tax receipts along with a mild rise in expenditure, curtailed the centre’s fiscal deficit to Rs. 2.7 lakh crore in Q1FY22, less than half of the Rs. 6.6 lakh crore recorded in the same quarter last fiscal amid the nationwide lockdown, and a moderate 18% of the FY22 B.E.
Despite this, the yield for the new 10-year G-Sec (06.10 GS 2031) has risen by 10-basis points since its introduction just three weeks ago, to 6.20% on August 2, 2021. We expect that the yield for the new benchmark may continue to inch up to as much as 6.3% in the ongoing quarter, in the absence of liquidity operations by the Reserve Bank of India, as its level may be inconsistent with the broader fiscal-inflation dynamics.
U.S. Fed’s Taper Timeline
In its July 2021 policy meeting, the Federal Open Market Committee of the U.S. Federal Reserve maintained a status quo on the Federal Funds Rate (at 0.0-0.25%) and the monthly quantitative easing purchase program of $120 billion. It continued to term the inflationary pressures as ‘transitory’, suggesting no immediate move to hike rates. While tapering was discussed in the meeting, the Fed Chairman indicated that more progress on the job market front is needed, before a final decision can be taken on the timing of tapering of bond purchases.
We expect the Rupee to trade in a range of 73.70-75.50 per dollar until policy normalisation by the U.S. Fed becomes imminent. The substantial war chest of foreign exchange reserves of $611 billion (as on July 23, 2021) accumulated by the RBI, will help to contain the extent of the depreciation in the Rupee, once the Fed eventually starts to taper.
Moves Seen In 2022
Looking ahead, we expect the MPC to commence policy normalisation in Q4FY22 after the domestic growth revival solidifies. We anticipate a change in the stance to neutral from accommodative in the February 2022 policy review, followed by a hike in the repo rate of 25 basis points each in the April 2022 and June 2022 reviews.
If inflation springs a negative surprise, the stance change may be preponed to the December 2021 policy review, with a lift-off in rates in February 2022.
Aditi Nayar is Chief Economist at ICRA.
The views expressed here are those of the author, and do not necessarily represent the views of BloombergQuint or its editorial team.