Radhika Rao, Senior Economist at DBS Bank
Asian policymakers have their hands full as much of the region is still caught up in the fight against the Covid pandemic. In some respects, there is less to worry about compared to last year, as people's ability to live through the pandemic has improved, the trade sector is faring well, and the external funding environment is favourable. Yet many lives remain disrupted, with Covid variants forcing most governments to extend curbs as vaccination progress has been slow.
The emerging markets policy landscape is, however, diverging. Benign inflation and inflationary expectations (with the exception of India and the Philippines), are expected to see most Asian countries delay policy normalisation, even as the US is expected to consider tapering asset purchases. On the other hand, as their economies reopen, select Latin American countries such as Mexico and Brazil are experiencing a strong rise in inflation spurred by cost-push forces and higher core as well as services inflation. This has led these countries to hike rates to anchor price expectations, whilst signalling that more is to come.
Two aspects will be top-of-mind when the Reserve Bank of India's Monetary Policy Committee (MPC) meets this week — durability of the rebound from the second wave as well as concerns over stickiness in inflation. Since the last rate review in June, policymakers have had two months' inflation prints on hand and a host of high-frequency indicators signalling that the economic momentum has largely recovered from the slump caused by the second wave of the pandemic.
Tempered optimism
The latest monthly RBI bulletin reflects this confidence yet flags a few risks. The hastened vaccination rollout, a turnaround in activity indicators, and buoyant agricultural output (if the monsoon catches up) are reasons to remain upbeat. However, a slower improvement in aggregate demand and the lag in reopening of services sector activity has tempered optimism. Risks of a third Covid wave and its impact also cloud the horizon. An RBI staff study (not the central bank's official forecast) pegged the Economic Activity Index for the June quarter GDP growth forecast at 22 percent YoY, slightly firmer than the MPC's official forecast and our GDP Nowcasting model. The firmer EAI is unlikely to lead to a reassessment in the annual estimates for FY22 growth, which was last adjusted down by 100 basis points in June to 9.5 percent YoY (DBS forecast 9.5 percent YoY).
We'll watch the tone on inflation after CPI inflation held firm at 6.3 percent YoY for a second month in June. Notwithstanding these elevated prints, RBI Governor Das had recently emphasised that inflation was still largely supply driven, referring to it as a temporary hump and expecting it to moderate by late 2021.
The minutes of the June meeting show that a few MPC members echoed the Governor's views; they took comfort that inflation was primarily between the target range and predominantly cost-push driven. Others were wary over rising inflation and suggested that policy gears would have been normalised earlier if not for the pandemic-led uncertainty.
Inflationary expectations continued to inch up, fuelled by higher input costs, exogenous factors (e.g., commodities, logistics costs), a spurt in retail fuel prices, and a reopening premium (goods to services inflation). Headline CPI inflation has stayed above the 4 percent target midpoint for 21 consecutive months and above the 6 percent tolerance band for more than half of that period. We expect price pressures to moderate for the rest of 2021 and bounce in the March 2022 quarter. Expect the MPC to dial up its FY22 inflation forecast from the present 5.1 percent YoY.
Accomodative stance likely to continue
Summing these up, the RBI MPC is expected to keep the repo rate at 4 percent and the policy corridor unchanged. Forward guidance will favour a continuation of the accommodative policy stance to guard against growth risks, especially the third Covid wave. The accompanying commentary will heed inflation risks through close monitoring but refrain from tweaking the policy levers for now.
Assuming the economy manages to skirt the risks of a third wave or that the onset of one does not materially derail the recovery process, we expect the narrative to focus on mopping up liquidity at a calibrated pace (a larger variable rate reverse repo-VRRR might be in the offing) before setting the stage for a reverse repo increase and change in policy stance around the end of 2021 or early 2022.
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