Hold on tight for change of gears

February 16, 2021 7:45 AM

Expect the process of liquidity normalisation by RBI to begin in mid-2021, the policy stance to shift to ‘neutral’ from ‘accommodative’ in Q3 (July-September), a 25 bps reverse repo rate hike in Q4 and 50 bps worth of repo rate hikes in H1-2022, with risks skewed towards further hikes

Muted credit growth suggests that the risk of higher liquidity overheating the economy remains low for now.

By Sonal Varma & Aurodeep Nandi

Inflation dynamics in December-January suggested that the retracement of previously elevated levels of vegetable prices was the primary force behind the fall in headline inflation from over 7% to below 5%. We believe that most of the correction is completed and while vegetable prices are likely to continue to assert marginal downward pressure in the February print, it will be smaller in absolute terms.

Early data for February suggest that our vegetable price tracker is -7.0% month-on-month versus -25% in January, while cereal prices that idiosyncratically spiked up in January are now correcting. Other categories that have driven up food price inflation in the recent past, such as tea (beverages CPI) and vegetable oils, are also lower in February. Finally, continued concerns about avian flu are likely to depress prices of meat and egg, but the large-scale culling of chickens suggests that demand-supply mismatches may cause prices to flare up later once the health concerns pass.

Changing dynamics of core inflation

Outside of food price inflation, we believe core inflation dynamics are also in transition. First, the rapid pace of normalisation due to the reduced pandemic fear factor suggests that idiosyncratic supply-side flare-ups that dominated price dynamics in 2020 are set to reduce. However, as the services side normalises, some upside inflationary surprises may still be in the pipeline.

Second, higher petrol and diesel prices owing to rising crude oil prices, alongside already steep indirect taxes, mean that transportation services are likely to remain relatively expensive. This dovetails with our third concern, i.e. higher commodity prices (crude oil, industrial metals, cotton) may prove to be a key upside risk as they were outsized driver of core inflation in the past.

Fourth, the strong cyclical upsurge in growth and firming demand suggests higher pricing power by producers and a stronger propensity for higher input costs to be passed onto consumers with a lag, signs of which were visible in January. This will also encourage importers to pass on to consumers the burden of higher customs duties and the Agriculture Infrastructure and Development Cess on some imports, which were introduced recently in the Budget. Finally, the sharp rise in telecommunication tariffs that pushed up the communications CPI through Q1-2020 is now set to create a favourable base effect in Q1-2021.

On balance, these factors suggest that while food price pressures may ease in the coming months, momentum in core inflation is likely to gather steam. We expect headline inflation to average slightly above 5% in February and March, affected by the unfavourable base from last year. We expect headline inflation to also average about 5% in Q2-Q3, before easing to about 4% in Q4. Overall, we expect headline CPI inflation to average 4.7% year-on-year in 2021, down from 6.6% in 2020, due to lower food prices, but core CPI inflation to remain elevated at above 5% on average, reflecting a gradual return of pricing power. Our forecasts suggest that there is some downside risk to the Reserve Bank of India’s CPI projection of 5.2% in H1-2021, although the continued surge in oil prices may easily erase this gain.

Industrial production—normalisation ahoy

The recovery in IP growth in December was largely on expected lines as the November data were skewed lower due to the different timing of Diwali in 2020, and largely remain in line with the broader theme of economic normalisation. As we elaborated in our recent chart pack, a combination of the lagged impact of easy financial conditions, stronger global growth, faster pace of normalisation even without a widespread vaccine rollout, higher government spending and base effects should trigger a strong cyclical growth uptrend in 2021. Consequently, we remain above consensus on our GDP growth outlook, expecting 13.5% year-on-year in FY22 from -6.7% in FY21, higher than RBI’s projection of 10.5% and -7.5%, respectively.

RBI—inching closer to the exit

The lower headline inflation reading amid improving growth prospects should offer some comfort to RBI and justify its ‘accommodative’ policy stance and status quo on policy rates. Muted credit growth suggests that the risk of higher liquidity overheating the economy remains low for now.

However, this is unlikely to remain a point of equilibrium for long, in view of the cyclical growth upsurge, signs of rising core momentum and fiscal activism. Rising oil prices may also lead to a pick-up in inflation expectations in the coming quarters. Balancing medium-term risks from the build-up of inflationary pressures will be as important to monitor, and are likely to call for a gradual normalisation of liquidity, in our view. However, this will require careful communications and deft policy manoeuvring as RBI also has to ensure the absorption of government borrowing without causing yields to escalate too sharply.

In our base case, we expect RBI to keep its policy repo rate unchanged through 2021, as the output gap stays negative (despite the cyclical recovery) and inflation remains within the band of 4%+/-2% (although above the 4% target). However, as growth normalises, so should the policy. 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), a 25 bps reverse repo rate hike in Q4 and 50 bps worth of repo rate hikes in H1-2022, with risks skewed towards further hikes.

Authors are research analysts, Asia Economics, Nomura

(Excerpted from Nomura Global Markets Research dated February 13, 2021)

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