By Anubhuti Sahay
The Monetary Policy Committee’s (MPC’s) decision to keep rates unchanged, taken at its December 6-8 meeting, was in line with our expectation. The repo and reverse repo rates were left unchanged; a section of the market was expecting a reverse repo rate increase. The committee maintained its accommodative stance, with a 5 to 1 vote in favour of this; Jayanth R Varma, professor at the Indian Institute of Management, Ahmedabad, and member of the MPC, voted against maintaining such a stance, similar to the pattern seen since the August policy meeting. He probably also expressed his disagreement on the current low reverse repo rate (he had done this in the October 6-8 meeting as well), although as an MPC member, he can only vote on the repo rate. We are likely to get more clarity on Professor Varma’s view on the reverse repo rate when the minutes are released on December 22. However, neither this decision to maintain status quo nor the voting pattern was surprising.
What did surprise us was the moderate inflation trajectory projection. The MPC’s average CPI inflation forecast for FY22 (ends March 2022) was kept unchanged at 5.3% (the CPI inflation forecast for Q3FY22 was raised to 5.1% from 4.5% previously, while that for Q4 was lowered). Its H1FY23 CPI forecast is 5.0%. This compares starkly with our forecasts of average CPI inflation of 5.6% in H2FY22 and 5.5% in H1FY23. In fact, in Q4-FY22, we expect CPI inflation to average 6%, closer to the upper threshold of the MPC’s mandated band. The MPC is mandated to keep headline CPI in the band of 4%+/-2%.
We acknowledge that the recent reduction in excise duty for retail fuel products and likely fading of supply disruption-led price increases can reduce inflationary pressure eventually. We also expect CPI inflation to moderate to an average of 4.5%; however, we do not expect this to become evident before H2FY23. Factors like (1) elevated commodity prices next year, especially those of metals, (2) larger passthrough of higher commodity prices to goods at the consumer end—we estimate that the gap between CPI and WPI goods inflation is at an unsustainable level of zero and expect it to bounce back to 200-300bps next year—and (3) a catch-up in services inflation, which has stayed lower than trend levels since the start of the pandemic, are likely to keep CPI elevated over the next three quarters.
We, therefore, think the MPC will have to revise its inflation forecast higher and respond to the sticky core and headline CPI inflation in its next meeting (assuming India doesn’t suffer from a third Covid-19 wave). We expect the reverse repo rate to be raised by 115bps, to 4.25%, from February-December 2022 and the repo rate to be hiked 75bps p, to 4.75%, from August 2022. We also expect the pre-pandemic corridor of 25bps to be restored by end-April 2022 (from 65bps currently). We believe the MPC and RBI are aware of the lingering and potential inflationary pressure, especially against a backdrop of major central banks dropping the word “transitory” while describing the upward trend in prices.
So, what explains the MPC’s cautious stance? We think the MPC wants to maintain monetary policy flexibility amid an uncertain economic outlook. RBI stated that the output gap is “very -very wide” and is likely to take several years to close.
The recent emergence of the Omicron variant of the SARS CoV-2 virus complicates the outlook on sustainability of the growth recovery as the risk of a third wave has increased. While vaccinations have progressed well, only 32% are fully vaccinated (with another 25% partially vaccinated). Additionally, the spillover impact from tightening financial conditions as major central banks normalise their monetary policy could affect sentiment. An increase in the reverse repo rate and/or providing explicit guidance on the timing of rate normalisation in the December policy meeting would have been a decisive signal on monetary policy. However, by deploying other tools, such as variable rate reverse repos (VRRRs), to guide the market rates higher, RBI has retained the flexibility to switch gears quickly without causing significant market volatility should a negative growth shock emerge.
That leaves us with the question, whether looser monetary policy in India will fuel inflationary pressures further? We don’t think so. Even though the central bank has maintained the reverse repo rate, it has actively managed liquidity over the past few quarters and guided market rates higher from 3.35% to 3.85%; this is closer to the repo rate of 4% rather than the reverse repo rate of 3.35%. We think RBI’s announcement to further expand the 14-day VRRR size to Rs 7.7 lakh crore from Rs 6 lakh crore and its statement on using 14-day VRRRs as the main liquidity management tool are likely to push market rates further higher. Monetary policy transmission happens via both market rates and lending/borrowing rates of banks; the former channel has already pushed rates higher. Bank credit growth has improved to 7% (November 19), boosted by both favourable base effects and increasing credit demand. However, the improvement in absolute credit demand is still in nascent stages and we do not think it can pose a risk to inflation as of now. Assuming that rate normalisation starts early next year, amid no fresh growth shocks, we think worries on looser monetary policy feeding into higher inflation is some time away.
The author is Head, South Asia, Economics Research, Standard Chartered Bank