Home >Opinion >Columns >RBI’s monetary policy is nearing an inflection point

The objective of the Reserve Bank of India’s (RBI’s) monetary policy committee (MPC) at the April meeting is straightforward: don’t rock the boat.

The second wave has increased the uncertainty around the near-term growth outlook as the peak in caseloads is not yet in sight. Rising infection cases will likely force more states to impose restrictions, disrupting economic normalization. Headline inflation looks likely to surprise 0.3-0.4 percentage points below the RBI’s projection for H1 CY2021, due to lower food prices. The output gap is still negative and the recovery has not yet been secured. Hence, all policy rates on hold and continuing with the accommodative stance appears the right strategy.

In our opinion, only the forward guidance needs to be refreshed, as the existing time-based guidance of remaining accommodative “into the next financial year" seems to have run its course. The MPC may choose to give a fresh time-based guidance (for one or two additional quarters) to stay accommodative, or shift to a state-based guidance. Markets seem to prefer the former, but we believe the MPC should opt for the latter to give itself manoeuvrability over the medium-term for the following reasons.

First, we expect the economic impact of the second wave to be limited, owing to less stringent lockdowns and as consumers and businesses have adapted to the new normal. High-frequency data suggest that while mobility and passenger transport has been hit, the goods sector continues to chug along. Growth should also be supported by medium-term tailwinds from ongoing vaccinations, a synchronized global growth recovery and lagged effects of easier financial conditions. Hence, while sequential growth may weaken during April-June, the RBI’s gross domestic product (GDP) growth projection of 10.5% y-o-y in FY22 already appears conservative.

Second, risks to underlying inflation are rising. The near-term inflation moderation is largely due to the volatile vegetable component, whereas a broad-based rise in commodity prices and higher freight costs have squeezed manufacturers’ profit margins and resulted in some of these costs being passed to consumers. Services inflation was subdued so far, but there is early evidence of higher prices in categories like recreation. Despite a negative output gap, the momentum in underlying inflation is running above 5.5%.

Third, the external environment could turn less benign for emerging markets, due to US growth outperformance. Higher US yields or the Fed’s plan to taper off its asset purchases could trigger capital outflows. India has a sufficient foreign exchange reserves buffer; however with real interest rates deeply negative and a weaker fiscal position, we think policymakers need to be cautious as investors could suddenly demand higher risk premium.

In developed economies, central banks seem willing to tolerate higher inflation, but this playbook should not be applied to India. In the former, inflation has undershot the target and inflation expectations are well anchored, whereas in India, inflation has overshot the midpoint target of 4% despite weak growth and inflation expectations are elevated. Tolerating higher inflation could result in fanning expectations even higher.

In this backdrop, the near-term versus the medium-term monetary policy strategy differ. While policy continuity could be the correct strategy in the near term amid the second-wave risks, the medium-term growth-inflation-external dynamics argue for gradual policy normalization and assigning a higher weight to inflation, relative to growth. In our opinion, the challenge for policymakers in coming months will be to taper without triggering a market tantrum. As clear a communication as possible on the speed, timing and sequencing of the normalization could help guide expectations.

Ultimately, we believe monetary policy needs to be forward looking and neither premature nor late in withdrawing accommodation. Patience is the keyword for now, but the clock is ticking.

Sonal Varma is chief economist (India and Asia ex-Japan) at Nomura Holdings.

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