The objective of the Reserve Bank of India (RBI) Monetary Policy Committee (MPC) at the April meeting is straightforward: do not rock the boat.
The second wave raised uncertainty around the near-term growth outlook, as the peak at Caseloads had not yet appeared. Rising infection cases are forcing more states to impose sanctions, disrupting economic normalization. Headline inflation is likely to surprise 0.3-0.4 percentage points over the RBI projection for the HB1CY2021 due to lower food prices. The output gap is still negative and recovery is not yet secure. Therefore, terminating all policy rates and continuing with the accommodation attitude seems to be the right strategy.
In our opinion, only the forward guidance needs to be refreshed, as the time-based guidance of accommodation for the rest of the “next financial year” seems to be running its course. The MPC may choose to provide the latest time-based guidance (for one or two additional quarters) to stay in the dormitory, or to switch to state-based guidance. Markets seem to like the former, but we believe the MPC should choose to give maneuver beyond the medium term for the following reasons. .
First, we hope that the economic impact of the second wave will be limited due to less stringent lockdowns and as consumers and businesses adapt to the new norm. According to high-frequency data, the commodity sector continues to chase, despite damage to mobility and passenger transport. Growth should also be supported by ongoing vaccinations, medium-term tailwinds, synchronized global growth recovery and the backward effects of easy economic conditions. Therefore, consecutive growth in the April-June period may weaken, with the RBI’s gross domestic product (GDP) growth projection of 10.5% already visible traditionally at YoY FY22.
Second, the risks to underlying inflation are growing. The near-term inflation control is largely due to the volatile vegetable component, but the broad-based rise in commodity prices and higher freight costs have reduced manufacturers’ profits and these costs have reached some consumers. Services inflation has eased so far, but there is precedent for higher prices in categories such as entertainment. Despite the negative production gap, the pace of underlying inflation is running above 5.5%.
Third, the external environment will become less vulnerable to emerging markets due to U.S. growth. The Fed’s plan to reduce high U.S. yields or its asset purchases will stimulate capital inflows. India has an adequate foreign exchange reserve buffer; However with real interest rates deeply negative and weak financial situation, we expect policy makers to be careful as investors may suddenly demand a higher risk premium.
In developed economies, it seems that the central banks are ready to withstand high inflation, but this playbook should not apply to India. Previously, the inflation target was undershot and inflation expectations were well anchored, but in India, despite weak growth and rising inflation expectations, inflation exceeded the midpoint target by 4%. Tolerating high inflation can further raise expectations.
In this context, the short-term versus medium-term monetary policy strategy is different. While the continuation of policy between second-wave hazards is the optimal strategy for the near term, the medium-term growth-inflation-external dynamics have consistently argued for policy normalization and placed a greater burden on inflation in relation to growth. In our opinion, the challenge for policy makers in the coming months is not to provoke market outrage. Communication as clearly as possible on speed will help guide the time and sequence estimates of normalization.
Finally, we believe that monetary policy is something to look forward to and that it is not too early or too late to withdraw accommodation. Patience is a key word right now, but the clock is tame.
Sonal Verma is the Chief Economist (formerly India and Asia Japan) at Nomura Holdings.