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Opinion | MPC should look through above-target inflation

CPI inflation is expected to average 4.4% in FY21, so it does not pose a major concern

Since the covid-19 pandemic erupted in India, the Monetary Policy Committee (MPC) has reduced the policy repo rate by 115 basis points (bps) in two out-of-cycle policy reviews, to 4%. In its last statement, the committee indicated its decision to retain the accommodative stance for as long as necessary to revive growth and alleviate the impact of covid-19 on the economy, while ensuring that inflation remains within the target.

This target is defined as a band of 2-6% for consumer price index (CPI) inflation. Even as the country continues to struggle with the impact of the covid-19 crisis and associated lockdowns on economic activity, inflation has unfortunately reared its head, posing a dilemma to policymakers.

The year-on-year (YoY) CPI inflation jumped from 5.8% in March 2020 to 7.2% in April 2020, when the lockdown was at the severest, corrected to 6.3% in May 2020, but softened only mildly to 6.1% in June 2020 as the economy unlocked.

Accordingly, inflation remained above target throughout Q1 FY2021, with supply disruptions and taxation changes outweighing the impact of flagging demand.

Moreover, we expect inflation to have risen in July 2020, as localized lockdowns and bouts of heavy rainfall led to fresh supply disruptions, especially for items such as vegetables, before resuming a downtrend in August 2020. Looking ahead, contrasting factors are at play, such as mismatches in labour availability, supply chain disruptions, moderate commodity prices and subdued demand for non-essentials, amid healthy kharif sowing and an as-yet favourable rainfall situation.

We expect the YoY CPI inflation to average 6.1% in H1 FY2021 and retreat to 2.7% in H2 FY2021, dampened by the favourable base effect for food items. Overall, CPI inflation is expected to average 4.4% in FY2021, guiding our view that inflation management does not pose a major concern at this point.

However, Indian GDP (at constant 2011-12 prices) is expected to shrink by as much as 9.5% in FY2021, as per our estimates at ICRA. We project the pace of YoY contraction at a massive 25.0% in Q1 FY2021, narrowing to 12.4% in Q2 FY2021 and 2.3% in Q3 FY2021. We are hopeful that GDP (gross domestic product) may eke out a mild YoY growth of 1.3% in Q4 FY2021, the likelihood of which remains contingent on the availability of a vaccine for covid-19.

In this context, the MPC could consider looking through the recent inflation prints, and cut the repo rate by 25 bps during its August 2020 review, instead of pausing until the CPI inflation recedes within the target range. (One basis point is one-hundredth of a percentage point.)

Moreover, the reverse repo rate could be cut by a sharper 35 bps. Given the considerable surplus in systemic liquidity, transmission is expected to be swift, supporting the case for front-loading of further easing. Nevertheless, we do not expect the decision to reduce rates to be unanimous.

The committee’s assessment of the space for further easing is awaited, to gauge whether we are at the end of the rate cut cycle. This, in conjunction with the outlook for government borrowings in H2 FY2021, will guide bond yields, that have been rather steady of late despite the building fiscal stress.

Our baseline estimate is that the government of India’s fiscal deficit will spike to 13 trillion in FY2021 from the budgeted 8 trillion. This exceeds the extent by which the Centre’s gross market borrowings have already been augmented, highlighting that a further expansion in its borrowing calendar for H2 FY2021 is inevitable.

In May 2020, the central bank had indicated that it shall support the smooth completion of the borrowing programme of the Centre and state governments, in the least disruptive manner. Details in this regard are awaited, in the absence of which bond yields may start moving towards the fiscal reality.

Aditi Nayar is principal economist at ICRA Ltd.

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