RBI Monetary Policy: A New Inflation Regime In India?

A June rate hike may be a no-brainer, but the path beyond—for inflation & policy—is where real uncertainties lie. By Sonal Varma.

<div class="paragraphs"><p>(Photograph:&nbsp;<a href=";utm_medium=referral&amp;utm_content=creditCopyText">Mediocre Studio</a> on <a href=";utm_medium=referral&amp;utm_content=creditCopyText">Unsplash</a>)</p></div>
(Photograph: Mediocre Studio on Unsplash)

Is India entering a new inflation regime, where average inflation over the medium-term will be much higher than the 2015-2019 average of around 4%? The future is uncertain, but this possibility can no longer be dismissed.

Inflation may be the top concern on everyone's mind today, but underlying inflationary pressures have been building for over eighteen months now, long before the current Russia-Ukraine crisis. Consider the following.

Underlying inflation, as measured by the 20% trimmed mean, which removes 20% each from the baskets with the highest and the lowest inflation rate each month, rose from 3.7% year-on-year in December 2019 (pre-pandemic) to 5.4% in February 2022 (pre-war), and has since accelerated to 6.6% in April. Inflation has also become more broad-based. The percentage of the Consumer Price Index basket (unweighted) registering inflation rates higher than 4% has risen from 33% in December 2019, to 67% pre-war, and to 72% as of April.

The reasons have changed over time, but inflation has remained persistently high. From mainly pandemic-related bottlenecks on food in 2020, to broader commodity-driven cost-push pressures in 2021, to a mix of supply-demand pressures currently.

This is now history, and policy has finally pivoted. The RBI’s Monetary Policy Committee has delivered an off-cycle 40 basis point repo rate hike in May. The government has also used a fiscal bazooka of export bans, excise duty cuts on fuel, and lower import/customs duty to tackle inflation. Yet, these measures may not be sufficient to offset the inflationary pressures for four reasons, in our view.

Inflationary Pressures Will Sustain

First, the global backdrop remains adverse. Even as there are signs of an incoming global growth slowdown, elevated food and energy prices remain a risk. A tight demand-supply balance has held up oil prices, despite lockdowns in China during April and May, revealing the impact of the drop in investment in fossil fuels. Higher energy costs have spilled over into food prices. With fertiliser availability and cost both an issue, there is a risk of lower crop yield and lower supply next year.

Food protectionism risks exacerbating these shocks. India is largely self-sufficient in food, but it may not remain completely immune.

Second, monetary policy works with long lags and is still ultra-accommodative. This is a key reason why we had been arguing for an earlier pivot. Even if one assumes faster transmission in this cycle, due to a greater proportion of loans linked to external benchmarks, the impact on inflation will only materialise next year. Fiscal interventions aimed at easing the cost of living crisis may also dampen the necessary demand adjustment.

Third, pipeline price pressures remain. Oil marketing companies are still incurring under-recoveries on petrol and diesel, which could be passed on to consumers if global crude oil prices remain elevated. Higher feedstock costs are an upside risk to food inflation. The ongoing power crunch and dependence on costlier imported coal will put upward pressure on electricity tariffs. The wide wedge between WPI and CPI inflation suggests there is a risk of further passage of higher input costs from firms to consumers.

Fourth, and importantly, second-round effects are yet to materialise. The cost of farm production and rising global food prices are likely to put upward pressure on minimum support prices.

The rising cost of living could lead to higher minimum wages. In turn, this could raise services inflation.

CPI rental price inflation remains benign and is yet to reflect rising rentals across cities. Higher food and fuel prices may spill over into higher inflation expectations. All of these could lead to inflation persistence.

No Easy Options

In our view, this suggests that even as policy action has begun, CPI inflation has not yet peaked, and following a brief dip in the May CPI reading, inflation could rise again, even exceeding 8% in some months during the next two quarters. On average, we expect CPI inflation at 7.2% YoY in FY23 with upside risks, above consensus (6.5%), and substantially above the RBI’s April projection of 5.7%. This requires a monetary policy response.

Critics may argue that India is not an exception and many developed and emerging economies have inflation rates much higher than the central bank targets; and since inflation is mostly supply-side driven, containing it via a substantial growth sacrifice is counterproductive.

Unfortunately, there are no easy options. India is a supply-constrained economy, and our inflation cycles have been more closely linked to supply-side cycles, both on oil and food. Moreover, since inflation expectations are not well anchored, the spillover from inflation, even if it is driven by supply-side factors, to wages can be fairly swift.

The risk of these second-order effects materialising in the coming months is non-trivial, and the policy choice is likely to boil down to either sacrificing growth now (for lower inflation later) or tolerating higher inflation now (lower growth later).

Fiscal policy can play a salutary role by not aggravating these inflationary impulses.

For monetary policy, it seems clear that rates are still too accommodative and rate hikes need to be frontloaded to get to neutral policy rates quickly, which we estimate around 5.5-6.0%. What seems less clear is where terminal rates lie. This is because risks are two-sided. Tighter global and domestic financial conditions could lead to a sharper slowdown in demand and reignite disinflationary pressures in this cycle due to the higher cost of living. However, it is equally possible that the uneven nature of the recovery keeps the top protected and tight supply results in food and energy prices remaining elevated for much longer than expected.

In light of this uncertainty, policymakers should allow data to dictate terminal policy rates, rather than pre-commit to any specific level at this early stage. Our current forecast assumes a 50 bps repo rate hike in June and a terminal repo rate at 6.25% by April 2023. We also expect further cash reserves ratio hikes in the second half of 2022, to bring liquidity surplus down to around 1% of net demand and time liabilities, as a means to accelerate policy effectiveness and transmission.

A rate hike in June may be a no-brainer, but the path that lies beyond that—both for inflation and policy—is where real uncertainties lie.

Sonal Varma is the Chief Economist for India and Asia ex-Japan at Nomura.

The views expressed here are those of the author, and do not necessarily represent the views of BQ Prime or its editorial team.