RBI Monetary Policy: Stay Vigilant, But Hold Fire

The signals are ominous, especially for emerging market economies looking at monetary policy support to guide growth back to pre-Covid normal – inflation is on the rise, forcing some to lift interest rates while a rapidly-strengthening United States economy has added its monetary implications. In India too, retail inflation rose above consensus expectations last month, core inflation remains firm, and growth is expected in positive territory the first quarter while hardening U.S. yields have filtered through. Yet, the monetary policy committee is likely to stay on hold at the April 7 policy review, preferring to wait and watch than respond to the changing dynamics unlike a few of its emerging market peers.

Four material developments distinguish the upcoming monetary policy assessment from the preceding one on Feb. 5. However, none of these impel participation in the emerging market economies rate hike cycle at this point. The macroeconomic policy framework, which is worldwide led by fiscal policy with monetary support, will therefore remain intact in India for now; even though external and domestic factors induce caution and watchfulness for potential repercussions, pointing to a tactical manoeuvre of monetary policy hereon.

One, inflation risks and uncertainties about its future evolution have risen within and abroad. The $1.9 trillion fiscal stimulus in the world’s largest economy and reserve issuer, the U.S., has brightened growth prospects - the world economy is currently predicted to grow 6% in 2021. But accelerating recovery has also sparked inflation expectations. There is fear and uncertainty that inflation may persist beyond a temporary spurt due to a strong comeback of suppressed demand, with reinforcements from stimulus cheques and vaccinated consumers.

An earlier than foreseen prospective tightening by the U.S. Federal Reserve and a possible repeat of ‘taper tantrum’ on scaling back of its bond purchases is a concern. As result, yields on U.S. long bonds hardened more than 50 basis points since February and 70 points this year.

Simultaneously, the steady rise in the price of oil and other commodities has escalated inflation pressures, forcing Brazil, Russia, and Turkey to recently raise interest rates more than the majority of experts anticipated.

India’s headline retail inflation also rose 5.03% last month, above market forecasts of 4.83%, in part by some food items but chiefly because of transport, assorted products, and services. The elevated core retail inflation has especially alarmed the MPC that has flagged its concern in successive reviews.

Ranging 5.4-5.6% since last July, core retail inflation jumped 26 basis points in February; minus its transport-communication component, the last four-month average is 4.5%. Seeing this evolution, the Reserve Bank of India governor has twice appealed for fiscal responses, viz. reduction of import tariffs and fuel taxes, but without success so far.

A disturbing aspect is the rebound in wholesale or producer price inflation. This has long stayed dormant, at least since mid-2013, but has surprised with its fast-paced and strong sequential pick-up in the last two quarters.

WPI inflation has been ignored for many years now; its linkages with retail inflation and respective strengths are neither well-studied nor fully understood. This imparts significant uncertainty to the inflation trajectory because the extent and duration of cost-push pressures introduced by accelerating producer inflation are not well known. The shrunk openness or trade-GDP ratio also sharpens domestic price reactions and shocks. In principle, the enormous slack in the labor market (raised and high unemployment, unequal recoveries in many sectors) implies the absence of wage pressures; the depressed demand suggests pass-through of higher costs may be one-off and dissipate. But that remains to be seen, warranting caution and watch.

Finally, several emerging market economies have begun responding to inflation and U.S. economic developments. Three of four inflation-targeting central banks, i.e. Brazil, Russia, and Turkey, rushed to tighten rates in panic over rising inflation; South Africa held back over its slow recovery. The loss of nerve in an inflation-targeting regime, which operates on psychology — conditioning inflation expectations around a target — and therefore allows seeing through to favour growth without fear of unhinging these, is concerning.

A holistic consideration of all of these factors is not likely to drive the MPC to similar action at this point, however. Global yield movements, increased inflation risks and uncertainty, additional fiscal pressures have tested the bond market’s resilience for over a month now with investors’ demand for higher premiums frustrating the RBI’s efforts and interventions to keep sovereign borrowing costs low or under-6%.

Since February, the RBI has accepted a modest increase in the benchmark bond yield, avoiding excessive divergence with the world. In another reflection of response to changing inflation-external conditions, the average rupee-dollar rate is stronger this year compared to the December value, 2.2% higher than last March, appreciating 5% in FY21. The central bank’s forward book built up to $47 billion in January from the mounting intervention in the forward market to balance liquidity and inflation. The two-phased, Cash Reserve Ratio normalisation – 3.5% effective March 27 and 4% from May 22 this year – further paves the way for discretionary market operations to fine-tune liquidity.

Along with such manoeuvres, India also has fiscal tools to check inflation and preserve monetary policy settings to facilitate post-pandemic recovery.

Public inflation expectations never really declined with the fall in inflation since 2014. For the last six months, the three-month and one-year forward expectations are close to or exceed double-digits. The nature and causes of retail inflation spikes also remain unclear in the context of supply-demand disruptions and destructions that are hard to gauge so soon. Time will also tell the evolution of U.S. yields, that have had a moderate domestic impact so far.

Finally, India’s output contraction is more severe than many other emerging market economies. The return to pre-pandemic output is anticipated to be very gradual, at least two years, while the recurrent Covid-19 wave is an additional threat.

Therefore, the changed configurations merit watchfulness but no action at this point. The MPC’s preference would be to retain the status quo. That said, it is quite likely India may have to normalise monetary policy sooner than thought and participate in the emerging markets rate hike cycle if the U.S. recovery maintains its acceleration. This, of course, will bring fiscal concerns to the forefront.

Renu Kohli is a New Delhi-based macroeconomist.

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