MPC unlikely to change policy rate in April 7 meeting
April 1, 2021 6:30 AM
RBI is expected to follow the February formula in the April meeting: Keep rates unchanged and stance accommodative, while highlighting inflation risks
RBI will move firmly (direction-wise) but gradually (speed-wise) on monetary policy normalisation
By Pranjul Bhandari & Aayushi Chaudhary
In March, India’s ongoing economic recovery was met with the unexpected winds of a new pandemic wave, rising oil prices and globally rising bond yields. As April starts, the second wave is intensifying.
How have the macroeconomic prospects for India changed in recent weeks? Will recovery be slower than anticipated at the start of the year? What would that mean for inflation? And how will RBI react? Will all of this impact the speed of exit from lose monetary policy?
The year 2021 started with a bang. Pent-up goods demand had led the way over the past few months and overall economic activity was already at pre-pandemic levels. Our expectation was that pent-up services demand, still 20% below normal, will be the main driver of growth over the next few months.
Alas, India was gripped with a second Covid-19 wave in March, alongside pressures from higher oil prices and higher bond yields. Its new active cases have overshot the September 2020 peak. Health experts worry about a rapidly transmissible strain doing the rounds. With local lockdowns mushrooming in certain parts, some mobility indicators have slowed a shade, though several other high frequency indicators have not. And it is likely that the pent-up services demand may be a notch slower in the next few months than anticipated at the start of the year. But will this be growth delayed, or growth lost?
New growth impulses will be delayed, not lost. To be sure, even if the pace of economic rebound has softened a bit, it is already at elevated levels. The services-led growth which could have pushed activity higher from here, will perhaps now be realised in its entirety in 2HFY22 instead of 1H . The faster vaccine rollout from April onwards, would help reach a critical mass in 2H, which could enable the rise in services growth. In fact, the GDP growth numbers in FY22 could now be more uniformly spread. Earlier 1H was benefitting from both low base effects and pent-up services demand. Now low base effects are likely to support 1H, and pent up demand is likely to support 2H.
The bad news is there could be two drivers pushing inflation up this year, higher oil prices and services inflation.
Oil prices are averaging c$20/b higher in 2021, and the impact of this is likely to spread widely across the economy, impacting the Centre and the states, corporates and consumers. Consumers will perhaps face a double sting—higher pump prices (particularly if excise duties on oil aren’t cut), and corporates passing over higher input costs to consumers. We look into these channels carefully and estimate that headline CPI inflation could be higher by 0.7ppt on the back of $20/b higher oil prices.
As services demand rises alongside the vaccine rollout, it could stoke services inflation, given that services inflation can’t be easily traded away like goods inflation, an as demand rises, service providers may adjust costs for two years together in 2021. We are already seeing some pressure build up in health and recreational services inflation, and core inflation pressures have started to spread, even if gradually. This would show up starkly in 2HFY22, as pent-up services demand could rise quickly.
Had it not been for the above two drivers of higher inflation, we would have forecasted CPI inflation at 4% in FY22. Incorporating pressures from higher oil and services, we forecast inflation in FY22 to average c5%, evenly spread between 1H and 2HFY22. Alongside we forecast core inflation in the 5.5-6% range (depending on the core inflation definition being used). Having said that, there are two silver linings in the inflation story. One, despite being higher than the 4% target, inflation is still under the 6% upper limit. Recall that it was over 6% for much of 2020.
The other silver lining is that in a counterfactual situation, inflation could have been much higher than we are currently estimating, in the face of an oil supply shock. WPI inflation is very sensitive to global commodity prices. But the relationship between Indian WPI and CPI is complex and has changed a lot. Pre-2015, there was a 60% positive correlation. Post2015, which is also the period of the inflation targeting (IT) regime, there is no strong one-way relationship between CPI and WPI; which is to say that all the rise in WPI does not necessarily show up in CPI inflation one-for-one.
Another exercise we undertook suggests that in the IT world, India’s headline CPI inflation is converging to core rather than the other way around. Which is to say that India’s CPI inflation is less prone to supply shocks than before.
Clearly, the growth and inflation story has changed since the start of the year. The economic rebound anticipated at the start of the year could soften due to the new pandemic wave, and then pick back up in 2H as vaccination progresses. CPI inflation is already higher than the 4% target, as it faces challenges from unexpectedly high oil prices (now) and services demand (likely in 2H).
The other uncertainties are: One, hard to read growth data. It is difficult to gauge output gap and potential growth in real time when data is volatile. A global problem, it is exacerbated in India, where accounting issues, at a time the Centre is repaying past dues to the FCI, are distorting growth prints.
Two, varied inflation experiences across the region. For Asia on average, headline inflation is around 110bp below inflation targets. China, Japan, Malaysia, and Thailand have negative inflation. Only India and Philippines have higher than target inflation. Will India converge towards the pan-Asian experience, or remain a standout case?
Three, volatile global yields and commodity prices. Both soared in March. Some of the rise could be a case of overshooting, but some pressures could remain. Differentiating between the temporary and the long-lasting may not be straightforward.
So what does RBI do when it is faced with lots of moving parts and uncertainties? How does it withdraw excess domestic liquidity so it does not become inflationary, without spooking the markets and hurting the recovery?
RBI will move firmly (direction-wise) but gradually (speed-wise) on monetary policy normalisation. On the one hand, we believe it will push short end rates up, closer to the 4% repo rate, so that real rates do not remain too negative for too long. On the other hand, it will provide adequate support so that the government’s borrowing costs don’t go up.
This balance, in our view, can be struck via liquidity switching (e.g. buying more bonds instead of dollars, and raising CRR back up and using the space for OMO purchases) as well as sterilised intervention (outright OMO purchases followed up by more variable rate reverse repo auctions). What could help here is our forecast of a smaller BoP surplus in FY22, lowering the need for the RBI to buy dollars, thereby focusing more on bonds. We expect RBI to start raising the reverse repo rate gradually in 2HFY22 in order to normalise the LAF corridor, but keeping the repo rate unchanged at 4% over the foreseeable future, or until the capex cycle rises in earnest.
One way forward for RBI is to differentiate between cyclical and potential growth. Calibrate liquidity in line with cyclical recovery. But move the benchmark repo rate only once the drivers of potential growth, for instance the investment rate, begins to rise in earnest.
In the upcoming April 7 meeting, we expect a similar outcome as the February meeting: (a) unchanged policy rates, (b) a promise to “continue with the accommodative stance as long as necessary”, and (c) an effort to tread the fine balance between inflation and growth. Highlighting the upside risks from inflation. Yet keeping the policy and liquidity stance clearly accommodative. Edited excerpts from HSBC Global Research’s India Economics report dated March 30, 2021
Bhandari is chief economist (India) & Chaudhary is economist, HSBC Securities and Capital Markets (India) Private Limited Views are personal