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India’s Monetary Policy Committee (MPC) is due to meet for three days starting 6 December. Increased uncertainty surrounding the economy’s growth outlook, against a backdrop of rising concern over the new covid variant, could be the key swing factor that sees the MPC delay the start of policy normalization, which we otherwise expected would commence at the December meeting, as growth data has improved considerably since the last policy review in early October.

Since the last policy review, India’s growth momentum has gained strength while inflation pressure increased on a sequential basis. Indeed, Google mobility data (excluding residential) is in the positive zone, the purchasing managers’ index (PMI) for services is at an all-time high of 58.4, the PMI for manufacturing is at a 10-month high of 57.6, exports rose to an all-time high in October, and GST collections have tracked consistently above the 1 trillion level in the past five months, reporting double-digit growth. On the inflation front, the sequential price momentum has hardened, more specifically in October, led by a broad-based increase in prices, as food, fuel and the core consumer price index accelerated, pushing the monthly momentum to a five-month high of 0.7% on a seasonally-adjusted sequential basis from 0.1% in September.

Against this backdrop, we expect growth outcomes to improve further, with a cyclical recovery to continue, helped by all drivers picking up pace. We expect gross domestic product (GDP) growth at 9.9% in 2021-22, higher than the Reserve Bank of India’s (RBI) current estimate of 9.5%.

It is against this improving trend in growth that we expect monetary policy normalization to start sooner rather than later, depending on the extent of risk that emerges from Omicron. As we are still at a stage of understanding this new variant, our base case expectations for growth and inflation are unchanged. So far, the measures being taken are related to increased testing and surveillance of travellers, especially from countries at risk. Omicron may pose downside risks to India’s near-term growth outlook, but the impact is likely to be contained to the quarter ending on 31 March 2022, as sequential growth could slow. In this light, to evaluate the potential risks from the new variant, we will be tracking: a) evidence of its transmissibility and virulence, b) restrictions being imposed by states, largely as a response to a potential sharp rise in cases and its impact on hospital capacity, and c) the pace of vaccination now that 46.9% of India’s adult population is fully vaccinated and at the current run rate we expect full coverage of adults by mid-March 2022. Further, we will closely track Google mobility indicators to look for initial signs of a probable impact on activity, and follow up with other high-frequency data to assess risks to growth.

As such, we will watch the December monetary policy statement for RBI’s assessment of risks posed by the new variant to growth and inflation, given the asymmetric impact that restrictions have typically had in the past, and in this context RBI’s level of comfort with pushing short-term rates higher eventually.

Beyond the December policy review, we believe that as India’s growth recovery becomes firmer, RBI should lift effective policy rates slowly into the positive zone from their current deep negative level. The first step will be to manage excess liquidity, for which RBI has been conducting variable-rate reverse repo auctions. The next step will be a reverse repo rate hike to normalize the policy rate corridor. The third step will be to increase the repo rate.

If the growth impact of Omicron is muted, then we expect RBI to take the second step in policy normalization at its February review, with an increase in its reverse repo rate. However, the quantum of any reverse repo increase in February is likely to depend on the extent of Omicron’s impact on activity. If it is minimal (i.e., our base case growth expectation holds), RBI could opt to hike the reverse repo rate by 40 basis points to adjust its policy rate corridor in one shot.

Going into 2022-23, we believe there will be greater evidence of a stronger and broad-based recovery, which should provide RBI enough comfort to take up repo rate hikes. Indeed, we expect these to start from the April meeting, contingent on a continued growth recovery, with cumulative increases of 150 basis points in 2022-23. We view these rate hikes as policy normalization rather than tightening. The policy rate path will be driven by a robust recovery in GDP growth, as we see it gaining strength with all drivers contributing. Indeed, we expect the country’s GDP growth path to be higher than its pre-pandemic path by the second half of 2022-23. Further, while policy rates rise—expected on the basis of our inflation forecast of an average 5% in 2022—we expect real policy rates to move into positive territory only by October 2022, with average real rates staying in negative territory over the next calendar year.

The current scenario is similar to that of the 2003-07 period, when growth was helped by both the domestic and external environments, as capital expenditure rose and macro stability indicators remained range-bound while growth was fuelled by higher productivity. At that time, real rates averaged 1.9%, and we believe that this cycle’s rise in real rates will be consistent with growth and inflation trends.

Upasana Chachra is chief India economist, Morgan Stanley. These are the author’s personal views

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