The Reserve Bank of India's monetary policy committee's (MPC) dilemma has worsened since it last met in June, with the two inflation readings released after the meeting shooting past the central bank's upper tolerance band of 6 percent.
The high-frequency data continues to improve, signalling that the worst is behind us. MPC’s statement and the minutes both had highlighted the upside risks to inflation, with adequate reference to the need for the government to take measures on the supply-side inflation.
However, we haven’t seen much traction on that front, which continues to keep upside risks to inflation intact. The progress of the monsoon has been tepid, weighing on kharif sowing, which remains about 8.9 percent lower than the last year.
The rains in the coming two months will be crucial to buffer from further supply shocks. More importantly, even before the inflation overshot, some MPC members in the June minutes were cautious on inflation, with one member noting that “clear signs of generalization in CPI (consumer price index) inflation setting in could be a tipping point where growth-inflation dynamics could alter”.
The members also highlighted that the “scope for accommodation existed since CPI inflation remained within the tolerance band”.
While we believe that inflation may trend below 6 percent from the next reading but upside risks remain amid weak monsoons and elevated global commodity prices.
Against this backdrop, MPC will have to tread carefully in managing the forward guidance, both on the policy and liquidity front. We believe that RBI’s room to ignore the inflationary risks is becoming increasingly difficult and it will soon have to get into action, though gradually.
In response to the inflationary threats, several emerging central banks have started to either hike policy rates or are tilting towards it. A few central banks in developed economies have started tapering or ending their pandemic relief asset purchase programmes.
There is already a growing debate on the timing, scale and pace of the RBI’s process of policy normalisation. Any guidance on the durability of the accommodative policy would bring in some sanity in the market.
Although as a lead signal, RBI is slowly letting lose its hold on bond yields and allowing a gradual settling on higher levels.
While in the upcoming policy we expect a status quo on rates and stance, the focus will be on the underlying tone of the statement, given the increasing risks of inflation.
We expect the RBI to revise its inflation outlook trajectory by 30-50bps across quarters, while the growth forecast of 9.5 percent may be only marginally tweaked accounting for the upside to their Q1FY22 projections— the central bank’s recent bulletin provides an estimate for Q1FY22 GDP of 22.1 percent compared to 18.5 percent mentioned in the June policy.
While near-term growth-related uncertainties will hold back MPC from changing the monetary policy stance in the August policy, it will be interesting to see any split in the voting pattern, given the improving growth momentum amid increasing inflationary risks.
Beyond August, we expect the onset of gradual monetary policy normalization, with liquidity management tools at the fore to reset the floor rate slowly within the policy corridor. For sure, the RBI will need to be more agile in using a variety of tools to calibrate policy.
Tools like the overnight voluntary retention route (VRR), increase in quantum of 14-day VRR and allowing non-bank participation in the VRR could be the playbook before a reverse repo hike in December.
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