The underlying framework of the Union’s budget, although less inflationary than a consumption-oriented budget would have been, has remained growth-oriented. This could have prompted the RBI to announce a formal path to standardization of policies. Moreover, since the last monetary policy review, the risks associated with the Omicron variant have been found to be lower compared to the Delta version. But those concerns have been replaced by new risks emanating from high crude oil prices and the possibility of aggressive policy action by the US Federal Reserve. Still, Mint Road chose to remain accommodating. Obviously, growth is the biggest concern.
The status quo positively surprised the markets which had expected a rise in reverse repo rates. The benchmark 10-year bond rate, which had started to rise a few months ago and had received further impetus from the sharp rise in the government’s borrowing program for the next financial year, has little softened. That said, even with a dovish stance, the RBI continues to normalize liquidity in a calibrated manner by overlaying a dynamic approach and restoring the February 2020 liquidity management framework.
The global situation, however, is different. With inflation surprisingly on the rise and seen as a potent threat, many central banks are moving toward faster tightening. Several emerging market economies, particularly those following inflation targeting, began raising interest rates last year in response to inflationary pressures from food and energy prices. With geopolitical tensions escalating in Central Asia and Ukraine, soaring energy prices are fomenting inflation even as global growth slows. Currently, China is the only major economy to cut rates to stem the sharp slowdown in domestic demand. Many Southeast Asian central banks remain accommodative as their inflation remains largely benign and some, such as the Bank of Thailand, remain tolerant of inflationary pressures.
Among the most important from a systemic point of view, the Bank of England was the first to raise its rates. Europe is also facing higher-than-expected inflation and the European Central Bank, which has so far kept its options open, is now expected to push normalization forward.
US Fed actions matter the most to India. Faced with rising inflation, which hit a multi-year high of 7% in December, the Fed reversed its “inflation is transitory” stance. He now sees continued pressure and has telegraphed a hawkish stance. S&P Global estimates the Fed can raise interest rates up to six times in 2022 starting in March. Although India’s monetary policy is mainly driven by domestic factors, we cannot completely ignore the actions of the Fed, as abrupt changes in policy create volatility on capital flows and foreign exchange markets, as seen during the August 2013 taper tantrum.
While India’s external accounts are sound (higher foreign exchange reserves and lower current account deficits and short-term external debt), its vulnerability stems from high domestic debt and deficit. Given the evolution of its communication, the shock of the actions of the Fed should be more important than before. For now, the RBI is reassured that the rupiah remains resilient despite the tightening of global financial conditions. Rising crude oil prices and current account deficits, however, may increase India’s vulnerability.
So far, the RBI has remained inflation-tolerant by staying firmly above its preferred 4% mark – the 2-6% midpoint it is targeting. This was necessary to support the economy hit hard by the pandemic and the fragility of the recovery since then.
Despite rapid progress in vaccinations, a subdued third wave and pro-growth fiscal policy, attention remains focused on growth as the RBI forecasts inflation to fall to 4.5% in the next fiscal year. He predicted economic growth of 7.8% next year, which, by the way, is also CRISIL’s forecast. We assume that Covid-19 will gradually weaken and that contact-based services – which have borne the brunt of successive waves of the pandemic – and are currently experiencing growth of 8-9% below their pre-Covid levels. pandemic – will engineer a rebound and script a full-scale recovery.
With so many moving parts, measuring and forecasting inflation is a daunting and risky business. Additionally, assessing the downturn in the economy, known as the output gap, has become more difficult with the pandemic-induced changes. This complicates the assessment of inflation. We expect retail price inflation of 5.2% over the next fiscal year.
High and rising crude oil prices remain an inflationary threat. We expect crude oil to remain in the $80-85 per barrel range in 2022, up 17% from 2021. This scenario will not only increase prices at the pump, but may also impact cascading to other prizes. Fiscal policy (tax cuts) may be the best way to deal with commodity price pressures, but given the already tight fiscal consolidation path, a further reduction in excise duties on oil was not considered in the budget.
The World Bank expects non-energy commodity prices to fall 3% in 2022. Despite this, non-energy commodity prices will still be 28% above 2019 levels, and pressure to pass on costs on end consumers will persist. Businesses have been unable to fully pass on soaring input costs, particularly those of key metals and energy, in 2021.
The broad-based recovery expected over the next fiscal year will facilitate the pass-through of input costs to end consumers and keep underlying inflation high. It should be noted that while headline consumer inflation fell to 5.2% in April-December 2021 from 6.6% in the same period a year earlier, core inflation ( which excludes energy and food) increased to 5.9%, against 5.4% percent.
Contrary to global trends, this low domestic food inflation pulled global inflation down. This trend could continue if the monsoons are normal this year. After six consecutive normal/near-normal monsoons, chances of monsoon failure increase, statistically speaking.
Due to heightened uncertainty, monetary policy will remain largely data driven. The RBI will need to keep its eyes peeled on price trends, which have so far surprised on the upside in many economies.
Joshi is Chief Economist, CRISIL Ltd