'RBI retains policy flexibility, positive tone on growth expectations with a tinge of caution'

At the August policy meeting, the RBI monetary policy committee retained its state-based guidance i.e. its implicit commitment to supporting growth and to retaining policy flexibility. The tone on growth expectations was positive but cautious. GDP growth forecasts were retained with a tweak in the quarterly profile – Q1FY22 was adjusted up and the remainder three quarters down.

The upward revision in the inflation forecast was moderately higher than expectations. The calibrated increase in the Variable Reverse Rate Repos (VRRR) auction size underscored the central bank's intent to lay the ground for an eventual policy normalisation, down the line. The normalisation process can take different shades which are visible in other pockets of the market. After a period of resistance (implicit yield curve control), risk-free INR10Y bond yield rose 20-23bps last month. Compared to 2020 lows, 10Y yields have been repriced higher by 30-40bps, building in the premium of a heavy borrowing program.

At the margin, there was higher caution on inflation and inflationary expectations, with the revised FY22 inflation projection within striking distance of the upper bound of the policy target range. An eye should also be kept on latent drivers of inflation. Firstly, the impact of supply-side inflation has only partly filtered through to the retail gauge barring fuel, as evident in the divergence between WPI and CPI inflation indicators. On the ground, higher crude prices are borne more by consumers than in the past oil upcycles. Notably, the oil-variant (petrol, diesel) inflation rate rose by double the pace in June, whilst that of cooking gas rose more sharply. Taxes now account for a little more than half of the retail prices, lending to downward rigidity to prices.

Secondly, companies are yet to fully pass on the input increases to consumers, which will likely accelerate if the third wave worries don’t materialise. Thirdly, as states ease restrictions, there is likely to be a shift away from goods to services-led inflation in the coming months. Most players are still operating at below capacity as per the recent softer PMI services surveys. As reopening continues, service providers will seek to reinstate their margins to make up for lost time and pass on higher input costs.

Rising inflation benefits borrowers and hurts savers. Inflation-adjusted real rates have been negative for more than a year, with the repo rate at 4 percent, eroding returns from banks’ deposits and incomes, thereby incentivising a push towards riskier assets/investments. Real incomes are also falling in the midst of the pandemic. Rural consumers were hit more adversely by the second wave; their terms of trade turned negative from non-food inflation rising at a faster clip than food (a proxy for incomes) amidst reduced fiscal support.

As growth gathers steam, persistently high inflation is likely to fuel the debate over the RBI MPC's inflation-targeting credibility, necessitating a gradual removal of the extraordinary stimulus and measures introduced last year. As this debate heats up in the coming months, we will closely track our proprietary DBS Financial Conditions Index for India to pick early signals of tightening in conditions.