As the Reserve Bank of India (RBI) and its Monetary Policy Committee (MPC) prepare for the April policy review, there is clear tension in the air.
The macroeconomic background continues to improve, and the economic recovery is becoming stronger. All but a few sectors violated their pre-Kovid level activities. Gross domestic product (GDP) growth is up to 11% in FY21-22, with occasional lockdowns coming back. Our forecasts suggest that a small partial lockdown is unlikely to make a dent in India’s recovery. Still, this recovery may not be enough. India’s production gap is likely to be negative by 2022 and monetary support is needed to regain lost output.
Inflationary losses appear to be balanced. Rising productive inflation, high fuel prices and seasonal pickups in food prices are the three main disadvantages that can keep headline inflation in check, but it is unlikely to physically plunge into major inflation. Educational research suggests that the high productivity wholesale price index (WPI) inflation has little effect on the Core Consumer Price Index (CPI) in an environment of negative production gaps. Rising fuel prices have been partly policy choice, and spillovers from food prices to core CPI have weakened significantly. All in all, we expect both the headline and core CPI inflation to stick, but by 2021 the trend will be low, which should give the RBI some space to suspend the policy.
True, our Taylor Rule simulations suggest that the next repo rate hike will only come in the second quarter of 2022. That is, in the new few quarters, the central bank will better serve by driving the economy “hot” and recovering lost. Output in the next few quarters. We believe that the RBI may also be waiting to confirm the durability of the economic recovery before actually offering a repo rate hike, which will not be clear before Q1FY22.
As an interim target, the central bank may focus heavily on transmitting past policy rate cuts. So far in the current easing cycle, only ~ 60% rate cuts have been transmitted to retail deposits, while lending rates have fallen by only 40% in policy rate changes since early 2019. We believe that there is room for further improvement in transmission, and that the RBI will allow full cuts to flow into loans and deposit rates by adhering to its commitment to maintain liquidity surplus and keep policy rates low. In fact, in addition to increased home savings, traditional and exceptional tools employed by the RBI are beginning to yield results, despite the epidemic, the inflow of funds is higher than previous year levels.
There has also been a tug war between the ‘Bond Vigilantes’ and the RBI since the February policy meeting. Despite the RBI’s view, yields have risen physically, rising 50-75 basis points across the curve, which is very steep, and the RBI has recently noted that yield growth could undermine the new recovery and reaffirmed its commitment to keep yields in check. The current MPC will disconnect between current market prices and expand the RBI’s policy priorities.
Communicating the eventual exit from its exceptional accommodation policy will always be a challenging exercise for the central bank. Through the steep yield curve, the market is giving signs that the risks of misalignment are high. However, the RBI has initiated this process by adjusting the liquidity level and normalizing the cash reserve ratio (CRR).
The next step in this process is to switch to the “State-specific forward guideline” to pave the way for exceptional accommodation withdrawal. This is done by normalizing the Liquidity Adjustment Facility (LF) corridor by increasing the reverse. The repo rate eventually set the stage for the Q2FY22 to raise the repo rate. However, the upcoming April Monetary Policy Conference will provide the RBI with an opportunity to bridge the communication gap and persuade market participants by speaking and walking in its intended way.
Rahul Bajoria is the Chief Economist at Barclays.