RBI should cross the river by feeling the stones
PremiumHeadline growth appears resilient now, but risks are skewed towards a slowdown
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PremiumA lot has been done already, policy works with lags and the future is uncertain. The current consensus narrative is as follows: Globally, the odds of a soft landing have risen, with lower inflation and a resilient jobs market in the US, lower energy prices in Europe and a faster reopening in China. In India, even as exports are contracting, a turnaround in private capex and the step-up in public capital expenditure means resilient domestic demand. Headline inflation has eased a shade below 6%, but core inflation is still sticky and is a concern.
Should this matter for monetary policy?
Yes, but not entirely. Monetary policy works with long lags—at least 12 months, in our view— so today’s decision has to be based not just on current data, but an assessment of what the growth-inflation path will look like in the coming year. Exactly one year ago, we were in the more hawkish camp. We did not predict the war, but after more than one year of elevated core inflation, risks appeared skewed towards higher inflation, due to the economic reopening and rising commodity prices, which called for withdrawal of accommodation. Today, after 300 basis points of policy rate hikes (from 3.35% to 6.25%) over the course of nine months, the next policy move is less clear cut.
What does the future hold for India?
There are early signs that headline inflation is softening. The momentum of super core inflation, which excludes the commodities that are part of the core inflation basket, rose by 4.5% on an annualized basis in December, down from 6% in previous months. But, one month does not make a trend and more evidence is needed.
Inflation expectations and wage growth have stabilized. We forecast an easing of headline inflation to 4.5-5.0% in 2023-24, below RBI’s projection of 5.2%, given the lagged effects of policy and lower cost-push pressures.
Headline growth appears resilient right now, but risks are skewed towards a slowdown. Globally, we have experienced one of the most synchronized tightening cycles in modern history and, as central banks stay higher for longer amid a slowing economy, the final demand can disappoint. China’s reopening is a positive, but its services-driven uptick is unlikely to have a major spillover effect on goods demand globally.
For India, growth indicators are a mixed bag, with exports and industrial cycle slowing, consumption chugging along, and infrastructure activity strong. On our forecasts, gross domestic product (GDP) growth is likely to slow to 5-5.5% in 2023-24, nearly 1 percentage point below the RBI’s projection of 6.5%. This is so, because we expect slowing exports to eventually feed through to a moderation of investment, and the full impact of the current tightening cycle is not yet seen.
What does this mean for policy?
Ultimately, monetary policy is more an art than science, and the judgement call is whether policy should react to today’s sticky core, which calls for another 25bp hike,or be more forward looking and pause. Regardless, it is time to be more data dependent.
Considering the hikes delivered thus far, the lags in policy, uncertainty over global prospects and downside risks to domestic growth-inflation outlook, policy can no longer remain on a pre-set course, and policymakers must assess each incoming data point to determine the next steps.
Some worry that this stance will dilute transmission but, given the external benchmarking of lending rates, transmission will still happen. The current stance of ‘withdrawal of accommodation’ is confusing, while data dependence is non-committal. If underlying inflation continues to surprise to the upside, then more hikes may be needed; otherwise, monetary policy can be left unchanged for the foreseeable future, until the macro outlook changes.
As the saying goes, it is time to cross the river by feeling the stones.
Sonal Varma is the chief economist (India and Asia ex-Japan) at Nomura.
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