While monetary policy normalisation is inevitable, it is unlikely to begin before the December policy meeting.
By Anubhuti Sahay
The IMF’s latest World Economic Outlook reiterates its three-phased policy-path in response to the pandemic: (i) “escape” acute crisis by prioritising health spending and focusing on most-affected segments; (ii) “secure the recovery” with emphasis on fiscal and monetary support, depending on available space; and (iii) “invest in the future” by advancing long-term goals.
India is likely transitioning from phase one to phase two. Per IMF recommendations, supportive policies are still required, in our view. However, a segment of the market is concerned that, with persistently high inflation, India might be pushed to normalise monetary policy sooner than required.
We believe monetary policy normalisation will remain contingent on vaccination coverage, pivotal in securing a recovery. Inflation matters, but given the unprecedented times, the priorities between inflation and growth have to be reordered, especially when price pressures are not driven by demand. The MPC is likely to convey a similar message at its August 4-6 meeting. In fact, it has stressed on this message in the past few meetings; we do not expect a different tone this time around, despite the high inflation print in the past two months.
Inflation in India has been elevated; almost 70% of the headline CPI prints since December 2019 have been above the MPC’s mandated upper threshold: medium term target of 4%, with a band of +/-2%. The May and June 2021 CPI prints of 6.3% y-o-y have once again put the spotlight on the MPC ahead of its August meeting.
However, an analysis of inflation internals makes it clear that high inflation in India is not demand-driven. We estimate that 55-60% of the inflation increase between FY20 and FY21 was driven by taxes on retail fuel products/liquor, the disruptive impact of COVID-19 on some global commodity prices, and higher prices of gold and crude oil.
The spike in CPI in May 2021—the month of second-wave lockdowns—is likely to moderate over the next few months. A similar trend, i.e., a sharp rise in m-o-m inflation, was observed in April 2020 during the first wave. Data availability issues and higher prices due to supply disruptions, among other factors, probably explain the spike, which led to a threshold shift in both headline and core CPI prints in April/May 2020 and over May 2021. However, we have also seen that such sharp m-o-m spikes during lockdown months ease later.
This is evident from post-first-wave data—for instance, core CPI recorded an average 1.1% m-o-m increase in April 2020, but the FY21 average m-o-m change was 0.5%; this was despite the sharp rise in excise duty for retail fuel, liquor and higher gold/crude oil prices. Of course, with higher commodity prices and better demand conditions, inflation may ease at a slower pace than last year, albeit still providing breathing space.
The MPC is likely to flag the distortionary impact of the factors mentioned above, even as it revises its FY22 CPI projection higher from the current 5.1% to 5.5%. The MPC could maintain its FY22 GDP growth projection at 9.5%, highlighting the muted impact of the second wave on growth; however, it is likely to flag the fragilities that might emerge should infections rise again.
As of end-July, India has fully vaccinated 7.9% of its total population; another 26.3% of the total population has received at least one dose. However, it will take time to reach herd immunity or even the lower threshold of vaccinating 50% of its total population. The high transmissibility of the current virus strain and global experiences (strain on medical facilities in Indonesia was significant versus the UK, even with similar number of cases, a few days back because of different levels of vaccination coverage) underpin the sustenance of recovery.
Overall, no action is expected, and the accommodative stance will likely be maintained. Expectations on measures to absorb high liquidity in the banking system remain low against the current backdrop, especially as this could be incorrectly construed as a step towards monetary policy normalisation.
RBI is likely to wait for a more opportune time to reduce the excesses in the surplus liquidity. However, we think it is important to contain any further growth in liquidity surplus as this could pose challenges later; strong measures might have to be deployed in a short span of time to bring the surplus to a more desirable level, especially when the growth recovery looks more secure. This in turn could lead to increased volatility in the market.
While monetary policy normalisation is inevitable, it is unlikely to begin before the December policy meeting. Calibrated measures to reduce the stock of liquidity surplus in the December policy meeting, followed by a 40bps increase in the reverse repo rate between February and April 2022 and a 50bps repo rate hike in Q2FY23 is the more likely course. Even after the normalisation process, the policy rate will likely remain below pre-pandemic levels, while the liquidity surplus would be higher than pre-pandemic levels.
Head (South Asia), Economics Research, Standard Chartered Bank