India’s monetary policy cycle is closer to a turning point
By Sonal Varma & Aurodeep Nandi
Industrial production (IP) growth fell to -1.6% y-o-y in January, vs an upward revised 1.6% in December (previously 1.0%), lower than expected. We had expected a slowdown in the y-o-y growth due to an unfavourable base, but the sequential rise was lesser, although still positive. On a seasonally adjusted basis, we estimate that IP rose by 0.2% m-o-m in January vs 1.6% in December. The disappointment was mainly due to weakness in consumer non-durables output growth, which also fell sequentially in annual terms in January (-6.8% y-o-y). Capital goods output growth rose sequentially, but its y-o-y rate fell by -9.6% y-o-y in January, due to an unfavourable base. Intermediate and infrastructure goods output growth rose 0.5% y-o-y and 0.3%, respectively.
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Overall, the main takeaway from the February inflation data are growing signs that a combination of higher commodity prices and normalising domestic demand are resulting in higher momentum in core inflation. Looking to March, the inflation dynamics appear adverse, not least due to adverse base effects.
On the positive side, vegetable prices have surprisingly continued to contract in March (-8% m-o-m in the first 11 days, exceeding the -5.8% recorded in February). However, the broader food and beverage basket continues to show higher price pressures, led by pulses, non-alcoholic beverages, and vegetable oils. Non-food price pressures are also significant in March. LPG cylinder prices have been hiked by ~10% m-o-m, which will impact fuel price inflation. Higher crude oil prices have led to elevated pump prices, which will drive up transport and communications CPI as well as feed through to higher input costs.
Although the fall in gold prices should offer some relief (for personal care CPI), the combination of higher global commodity prices and rising pricing power of firms, in light of the cyclical growth recovery, means higher propensity of these price pressures to be passed on to consumers, in our view. Finally, we expect services inflation to rise as the economy rapidly normalises. Consequently, CPI inflation is tracking 5.0-5.5% in March, led by both food and core inflation – the latter is likely to rise above 6%. We expect a moderation in April to 4.0-4.5% due to favourable base effects, before inflation returns to trending at 5.0-5.5% till Q3.
Overall, we expect inflation to average around 5% in 2021, while core inflation is expected to average higher at ~5.5%. Growth remains on a steady recovery path and despite the negative surprise on January IP, the broader theme of normalisation remains intact, in our view. Early data for February like merchandise trade, GST, PMI and auto sales point to continued upside momentum, and our composite leading indicator is also pointing higher.
Overall, activity remains on an uptrend in Q1. A key near-term risk is rising pandemic cases, although this is concentrated in a few states (mainly Maharashtra) and is not yet a pan-national second wave. Our base case remains one of an imminent business cycle recovery, aided by tailwinds from the lagged impact of easy financial conditions, frontloaded fiscal activism, strong global growth and the ‘vaccine pivot’.
India has inoculated close to 2% of the population, and we expect a vaccine pivot point to be reached in Q3 this year. We project GDP growth at 12.4% y-o-y in 2021, up from – 6.9% in 2020. For FY22 (year-ending March 2022), we are above consensus at 13.5% GDP growth.
On policy, we maintain our base case that both policy rates (repo and reverse repo) and the accommodative policy stance will be maintained at the April 7 policy meeting. While growth prospects are improving, the output gap is still negative and the recovery is not yet on durable foundations. Meanwhile, inflation is broadly within the target range, although upside risks have risen.
RBI’s willingness to maintain accommodation can also be explained by its trilemma of controlling yields, ensuring smooth absorption of the government’s borrowing, while leaning against currency appreciation, all while keeping excess liquidity under control. The balancing act has been compounded by global factors like rising US Treasury yields and higher oil prices, which add to the upward pressure on domestic bond yields.
However, we believe India’s monetary policy cycle is closer to a turning point. RBI’s current inflation outlook assumes headline inflation averaging 5.2% in H1 2021 and 4.7% in H2, but there are upside risks to its H2 forecasts, in our view, given rising input cost pressures. Moreover, we expect growth to continue to recover and the output gap to close by Q1 2022. As growth normalises, so should policy.
In the coming months, as confidence around the growth recovery increases and core inflation momentum rises further, we believe the RBI will need to draw a distinction between its policy stance on rates (that reacts to the changing macro landscape) vs that of its liquidity management (which prioritises ensuring orderly evolution of yields).
In our base case, we expect the RBI to keep its policy repo rate unchanged in 2021. However, we expect the process of liquidity normalisation to begin in mid-2021, the policy stance to shift to ‘neutral’ from ‘accommodative’ in Q3 (July-September), and a 25bp reverse repo rate hike in Q4. This is likely to be followed by 50bp worth of repo rate hikes in H1 2022, with risks skewed towards further hikes.
Varma is chief economist, India and Asia ex-Japan, and Nandi is India economist, Nomura Views are personal
Excerpted from Nomura Global Markets Research’s Asia Insights report dated March 12, 2021