Inflation outlook: Status quo from RBI on Omicron uncertainty

As base effect wanes, inflation to harden to an uncomfortable 5.5-6% in December-March FY22, close to upper end of MPC’s medium-term target range. With elevated input prices, either margins will be further squeezed or higher prices will contain the consumption recovery in H2FY22

On balance, we expect the CPI inflation to print at around 4.7% in November 2021.
On balance, we expect the CPI inflation to print at around 4.7% in November 2021.

The Monetary Policy Committee (MPC) meets next week amidst renewed uncertainty generated by the Omicron variant of Covid-19. When it had last met, in October 2021, it had remarked that with output trailing the pre-pandemic level, recovery remains uneven and dependent upon continued policy support. With the Q2FY22 GDP marginally exceeding the pre-Covid-19 level, will the MPC conclude that economic recovery is broad-based and durable enough, and policy support can be weaned off? Unlikely, in our view.

To recap, the October policy review had contained no major surprises. The MPC had voted unanimously to maintain the policy repo rate at 4%. In a split vote, it had indicated a continuation of the accommodative stance for as long as necessary to revive and sustain growth and continue to mitigate the impact of Covid-19 on the economy, while ensuring that inflation remains within the target going forward. The MPC had retained its FY22 growth forecast at 9.5%, pegging the Q2FY22 expansion at 7.9%, while reducing its inflation forecast for this fiscal by 40 bps to 5.3%. As expected, RBI had simultaneously refrained from hiking the reverse repo rate, while continuing the move towards liquidity normalisation.

The recent macroeconomic developments are decidedly mixed, both on the inflation and growth front. Encouragingly, the CPI inflation dropped from 5.3% in August 2021 to 4.3% in September 2021, before rising mildly to 4.5% in October 2021. The Centre announced a welcome excise cut on petrol and diesel, which was followed by VAT reduction on these by several states. The softening impact of this is expected to be visible in the non-core CPI inflation for November 2021.

Additionally, the outlook for the rabi crops is bright, softening the expected food inflation trajectory. Benefiting from healthy moisture levels, the area sown under rabi crops recorded a healthy year-on-year (y-o-y) increase of 7.3% as on November 26, 2021. This was led by higher acreage under some high inflation items such as oilseeds as well as pulses and wheat, partially offset by lower area sown under rice and coarse cereals.

However, vegetable prices have surged. Moreover, producers grappling with cost pressures emanating from surging global commodity prices and logistics costs have announced price increases in a number of sectors, which is likely to keep core inflation elevated.

On balance, we expect the CPI inflation to print at around 4.7% in November 2021. As the base effect wanes, we anticipate that it will harden to an uncomfortable 5.5-6% in December-March FY22, edging close to the upper end of the MPC’s medium term target range of 2-6%. Overall, the CPI inflation is now expected to average 5.5% in FY22, 20 bps higher than the forecast of 5.3% made by the MPC in its October 2021 review.

Signals regarding the momentum of economic growth are also mixed. India’s real GDP expanded by 8.4% in y-o-y terms in Q2FY22, surpassing the MPC’s and our own forecast of 7.9%. With this, the absolute level of GDP reverted mildly above the pre-pandemic level of Q2FY20, one of the metrics being watched by the MPC. However, we contend that broad-based signs of a durable recovery were missing in the disaggregated GDP data.

Encouragingly, gross fixed capital formation displayed a rise of 1.5% in Q2FY22 relative to Q2FY20, echoing the trend in capital goods output and government capital spending. However, private and government consumption expenditure in Q2FY22 lagged their pre-Covid-19 level by 4% and 17%, respectively. The impact of this was offset by a surge in valuables relative to the pre-Covid-19 level of Q2FY20, led by the near tripling in imports of gold and silver.

At constant 2011-12 prices, the valuables in Q2FY22 exceeded the Q2FY20 level by Rs 0.8 trillion, much higher than the mild absolute rise of Rs 0.1 trillion in GDP during this time period. This is the chief reason why we are circumspect, despite the Q2FY22 GDP exceeding our forecast.

Moreover, some key sub-sectors such as manufacturing, mining and construction displayed a lower GVA growth in Q2FY22 than the volume expansion indicated by the IIP, suggesting that rising input costs bit into corporate margins. Looking ahead, rising domestic vaccine coverage and fuel tax cuts will boost confidence and reinvigorate demand, pushing up volumes. However, with elevated input prices, either margins will be further squeezed, or higher prices will contain the consumption recovery in H2FY22.

After a broadly healthy festive season, some indicators have displayed a flagging momentum in November 2021. For instance, the daily average generation of GST e-way bills declined considerably to 2 million in November 1-28, 2021, from the record-high 2.4 million seen in October 2021. Electricity growth dipped in November 2021 to a feeble 2%. Moreover, vehicle registrations contracted on a y-o-y basis. On the other hand, the November PMI rose further, mirroring the improved mobility data.

Following improved tax revenue visibility, we anticipate a brisk pace of central and state government spending in H2FY22, even as the base effect is particularly unfavourable in Q4FY22. Moreover, the recent releases of the remaining tranches of the back-to-back GST compensation loan as well as an extra instalment of central tax devolution would boost the cash flows of the state governments, nudging them to step up their spending. This is growth-positive, as state expenditure is an important component of brightening business sentiment and economic activity.

Disappointingly, the discovery of the Omicron variant has reignited uncertainty regarding the strength of global demand and cross-border flows, as well as the insurance provided by the current Covid-19 vaccines, while at the same time triggering some correction in commodity prices.

In light of the renewed uncertainty, we expect a status quo from the MPC and RBI in the December 2021 policy review on the stance and rates. However, the tone may shift to signal an impending change in the monetary policy stance to neutral in the February 2022 policy review, as long as Omicron doesn’t necessitate fresh lockdowns in the coming weeks. We expect the stance change to be accompanied by a 15 bps hike in the reverse repo rate by RBI in February 2022, narrowing the policy corridor to 50 bps from the current 65 bps.

Thereafter, our base case continues to pencil in hikes of 25 bps each in the repo and reverse repo rates each in the April 2022 and June 2022 reviews, followed by a reassessment of the durability of the growth revival as policy support is withdrawn.

The author is chief economist, ICRA

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