Things can only get more difficult for the RBI MPC
Average inflation over the past year and a half has exceeded the Reserve Bank of India’s (RBI) 6% upper tolerance level, despite the large negative output gap. Since the June Monetary Policy Committee (MPC) meeting, inflation has surprised on the upside again, suggesting that the RBI’s inflation projections will need to be revised up. In response, the governor of the RBI has already indicated that it is a “temporary surge” and not a game changer for monetary policy.
This deliberate ‘head in the sand’ stance on inflation is understandable, as the prevailing judgment sees the current inflation surge as supply-driven and therefore expects it to return to the target range. from 2 to 6% as the economy becomes more unblocked.
Moreover, the resumption of growth after the troughs of the second wave of covid has been faster than expected, although the sustainability of this recovery remains uncertain. Given the still low vaccine coverage, the risk of further outbreaks from the pandemic is not negligible, and any hasty withdrawal of political support could exacerbate growth problems.
Therefore, even if the MPC faces a growth-inflation trade-off, August’s monetary policy decision should be a snap. We expect the RBI to maintain its GDP growth projection (gross domestic product) at 9.5% year-on-year in fiscal 22 (year ending March 2022), while revising upward. the average CPI (Consumer Price Index) inflation projection for FY22 at around 5.5%. of the 5.1% projection presented in June.
The MPC will likely continue to favor growth over inflation, as the overall policy stance is expected to remain accommodative.
But is inflation really transient? In our view, there is a growing risk that inflation will end up being more persistent than expected.
Indeed, inflation is not currently demand driven, but supply side shocks remain a significant risk. If India is hit by a third wave, it would represent the third time in two years that a supply-side foreclosure shock has hit inflation. Prices tend to be downwardly rigid in India and only partially reverse when the economy breaks down.
There are other factors to consider. The cumulative build-up of cost pressures, including the costs of raw materials and logistics, leads companies to pass more of the costs on to consumers.
There are labor shortages due to reverse labor migration, although we would expect this to ease over time as workers return. Greater consolidation in each sector can lead to greater pricing power for the remaining players, and some sectors are strengthening their balance sheets (think telecommunications) by raising prices.
Over the next six to twelve months, the pressures on the demand side are also expected to become more evident, as the majority of the adult population is vaccinated. Inflation in services, which has been absent so far, is likely to increase.
Policy has been much more tolerant of inflation during the pandemic, and rightly so; but with rising inflation expectations, the concern is that inflation could become more entrenched and trigger a negative feedback loop and loss of policy credibility.
Yes, the economy is not yet out of the woods, but a sustainable recovery in growth requires a health policy response through accelerated vaccinations and more targeted credit and fiscal support. Tolerating high inflation for too long can become counterproductive.
In 2019 and 2020, the biggest challenges facing the Indian economy were the risks of growth and financial stability. Monetary policy has done a remarkable job of countering these risks with rate cuts, easy liquidity, and ensuring that financial conditions do not tighten prematurely.
In the future, the main challenge for monetary policy will, in our view, be a more solid inflation trend than currently expected.
The remedy is not necessarily a rapid withdrawal of political support, but rather a gradual prioritization of inflation over growth which gradually wears the economy away from the current ultra-low liquidity. Not hastily, but not late either.
Sonal Varma is the Chief Economist for India and Asia Excluding Japan at Nomura, and Aurodeep Nandi is the Economist in India at Nomura.
Never miss a story! Stay connected and informed with Mint. Download our app now !!