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Home / Economy / The going may only get tougher for the RBI MPC

They say that beauty lies in the eye of the beholder. Evidently, so does inflation.

The average inflation over the past year-and-a-half has exceeded the Reserve Bank of India’s (RBI) upper tolerance level of 6%, despite the large negative output gap. Since the June monetary policy committee (MPC) meeting, inflation has again surprised to the upside, suggesting the RBI’s inflation projections will need to be revised higher. In response, the RBI governor has already indicated that this is a “temporary surge" and not a game-changer for monetary policy.

This deliberate ‘head-in-the-sand’ stance on inflation is understandable, as the prevailing judgement views the current bout of inflation as driven by the supply side and therefore expects it to revert back to the 2-6% target range as the economy unlocks further.

Moreover, the growth recovery from the second covid wave lows has been swifter than expected, although the sustainability of this recovery remains uncertain. Given the still-low vaccination coverage, the risk of further pandemic-induced bumps is non-trivial, and any hasty withdrawal of policy support could compound the growth challenges.

Therefore, even as the MPC faces a growth-inflation trade-off, the August monetary policy decision should be a cakewalk. We expect the RBI to maintain its GDP (gross domestic product) growth projection at 9.5% year-on-year in FY22 (year ending March 2022), while revising up the average FY22 CPI (consumer price index) inflation projection to around 5.5% from the 5.1% projection outlined in June.

The MPC will likely continue to prioritize growth over inflation, with the overall policy stance likely to remain accommodative.

But is inflation really transitory? In our view, there is a growing risk that inflation may end up being more persistent than expected.

Indeed, inflation is not currently demand-side driven, but supply-side shocks remain a material risk. If India is hit by a third wave, it would represent the third time in two years that a supply-side lockdown shock has hit inflation. Prices tend to exhibit downward rigidity in India and reverse only partially when the economy unlocks.

There are other factors to consider. The cumulative build-up of cost pressures, including raw material and logistics costs, is leading companies to pass more of the costs to consumers.

There are labour shortages due to the reverse migration of labour, although we would expect this to ease over time as workers return. Greater consolidation in each sector may lead to more pricing power for the remaining players, and some sectors are strengthening their balance sheets (think telecom) by hiking prices.

Over the next six to 12 months, demand-side pressures should also become more evident, as the majority of the adult population is vaccinated. Services inflation, which has been absent thus far, will likely rise.

Policy has been much more tolerant of inflation during the pandemic, and rightfully so; but with inflation expectations drifting higher, the worry is that inflation could become more entrenched and trigger a negative feedback loop and loss of policy credibility.

Yes, the economy is not yet out of the woods, but a durable growth recovery requires a health policy response via accelerated vaccinations and more targeted credit and fiscal support. Tolerating high inflation for too long can become counterproductive.

During 2019 and 2020, the biggest challenges facing India’s economy were growth and financial stability risks. Monetary policy has done an outstanding job countering these risks with rate cuts, easy liquidity and by ensuring that financial conditions do not tighten prematurely.

As we look ahead, the key challenge for monetary policy, in our view, will be an inflation outturn that is stickier than is currently expected.

The remedy is not necessarily a rapid withdrawal of policy support, but rather a gradual prioritization of inflation over growth that progressively weans the economy off the current ultra-loose liquidity. Not hastily, but also not overdue.

Sonal Varma is the chief economist for India and Asia ex-Japan at Nomura, and Aurodeep Nandi is the India economist at Nomura.

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