The RBI Monetary Policy Committee (MPC) will be going into the August policy meeting with inflation exceeding the 6% upper bound. While the need to support growth will dominate the policy backdrop, some concerns are bound to be raised on the visible inflationary pressures in the near to medium term. However, the negative output gap rather than the positive inflation gap will keep the MPC’s stance and overall tone unchanged, at least, till it becomes more confident of the growth prospects. In fact, the minutes that will follow a couple of weeks later will be important to watch for any divergence in members’ views of growth-inflation dynamics.
India’s inflation prospects will be shaped broadly by: (1) easing of supply frictions due to the second wave led lockdowns, (2) global commodity price movements, and (3) the impact of monsoon on food prices. The supply disruptions impact was prominently visible in May, much milder in June, and will ease over the next few months. Risks of higher crude oil prices have reduced after the OPEC+ meeting. Metal prices have seen some stabilization though levels remain much higher over the year. The incipient risk, though, is the weak rainfall seen over most of July. This is reflected in around 9% lower kharif sowing (compared to the previous year) till July 23. This will be a concern for the MPC given the risks of higher-than-expected food inflation in 3QFY22.
Inflation in 1QFY22 has been 40 bps higher than the estimates that RBI indicated in the June policy. Barring a spike in food inflation, we expect inflation to glide lower to average around 4.7% in 3QFY22 (in line with the RBI’s forecast).
The present concern, however, will be centered on growth. June and July have seen a turnaround in economic activity from May levels. Indicators such as mobility indices and e-way bill generation rate are back to pre-second wave levels. However, the medium term growth outlook hinges on broadly two factors: (1) pace of vaccination, and (2) any further Covid waves. Neither of these factors provide much comfort for now. Timing of subsequent Covid waves remains uncertain and poses a clear risk to growth outlook in case they were to play out.
Vaccination rate which picked up in June remains at around an average of four million doses per day. Till now, around 26% of the population has received the first dose while around 7% is fully vaccinated. For context, if the daily rate were to average around 6.5 million doses for the rest of the calendar year, 45-50% of the population could be fully vaccinated. Services sector, which forms around 55% of GVA, is unlikely to recover fully unless vaccination rates pick up and contact services are normalized.
In an inflation targeting framework, a Taylor rule type approach would consider the balance between the inflation gap (from the target) and output gap. With projected growth of around 9-9.5% in FY2022, the size of the economy barely crosses the FY2020 levels at the end of FY2022. The output gap will close gradually and given the uncertainty of growth, the inflation gap is unlikely to be the dominant worry for the RBI immediately. The RBI will view the recent trend in inflation as transitory as it waits for some of the exogenous factors such as global commodity prices, supply disruptions, etc. to ease. The RBI will maintain the liquidity outlook in line with its policy stance. However, risks of higher inflation will be adequately highlighted. The August policy will be status quo with the minutes possibly highlighting some divergence of views and outlook.
(Suvodeep Rakshit is a Senior Economist in Kotak Institutional Equities. Views expressed are the author’s own.)