A growth-focussed monetary policy

The status quo has positively surprised markets who had pencilled in a reverse repo rate hike. The benchmark 10-year yield, which had started to ascend a few months back, and got a further lift from the sharp rise in the government’s borrowing programme for the next fiscal year, softened a bit. That said, even with an accommodative stance, the RBI continues normalising liquidity in a calibrated manner by layering a dynamic approach and restoring the liquidity management framework of February 2020.

The global situation, however, is different. With inflation surprising on the upside and being viewed as a potent threat, many central banks are tilting towards faster tightening. Several emerging market economies, especially those following inflation targeting, had started raising interest rates last year in response to inflationary pressures from food and energy prices. With geopolitical tensions in Central Asia and Ukraine escalating, the spike in energy prices is fomenting inflation even as global growth slows. Currently, China is the only major economy cutting rates to stem sharply slowing domestic demand. Many south-east Asian central banks are staying accommodative since their inflation remains largely benign and some like the Bank of Thailand remain tolerant to inflationary pressures.

Among the systemically important ones, the Bank of England was the first to raise rates. Europe, too, is facing higher-than-anticipated inflation and the European Central Bank, which has so far kept its options open, is now expected to advance normalisation.

Actions of the US Fed matter most to India. Faced with rising inflation, which touched a multi-year high of 7 per cent in December, the Fed made a U-turn on its “inflation is transitory” stance. It now sees persistent pressures and has telegraphed a hawkish stance. S&P Global believes the Fed can hike interest rates as much as six times in 2022 starting March. Although India’s monetary policy is primarily governed by domestic factors, we cannot completely ignore the Fed’s actions, since abrupt policy changes create volatility in capital flows and currency markets, as was witnessed during the taper tantrum of August 2013.

While India’s external accounts are healthy (higher foreign exchange reserves, and lower current account deficits and short-term foreign debt), its vulnerability arises from high domestic debt and deficit. Going by its evolving communication, the shock from Fed actions is set to be bigger than before. For now, the RBI derives comfort from the rupee remaining resilient despite tightening global financial conditions. Rising crude oil prices and current account deficits can increase India’s vulnerability though.

The RBI has so far remained tolerant to inflation staying decisively above its preferred 4 per cent mark — the midpoint of 2-6 per cent that it targets. This was needed to support the economy hit hard by the pandemic and the fragility of recovery since then.

Despite the swift progress in vaccinations, a mild third wave and a growth-supportive fiscal policy, attention remains focussed on growth as the RBI sees inflation coming down to 4.5 per cent next fiscal. It has projected the economy to grow at 7.8 per cent next year, which, incidentally, is CRISIL’s forecast as well. We assume that Covid-19 will gradually weaken, and contact-based services — which bore the brunt of successive waves of the pandemic — and are currently growing 8-9 per cent below their pre-pandemic levels — will stage a bounce-back and script a broad-based recovery.

With so many moving parts, assessing and forecasting inflation is an arduous and risky business. Plus, gauging the slack in the economy, referred to as output gap, has become harder with the pandemic-induced changes. This complicates the assessment of inflation. We expect retail inflation at 5.2 per cent in the coming fiscal.

High and rising crude oil prices remain an inflation threat. We expect crude oil to remain in the band of $80-85 per barrel in 2022, up 17 per cent from 2021. This scenario will not only increase pump prices, but can also have a cascading effect on other prices. Fiscal policy (tax cuts) is perhaps the best way to deal with the pressures from commodity prices, but given the already-stretched fiscal consolidation path, a further cut in excise duty on oil was not envisaged in the budget.

The World Bank expects non-energy prices to fall 3 per cent in 2022. Despite that, non-energy commodity prices will still be 28 per cent above 2019 levels, and the pressure to pass on the costs to end-consumers will persist. Companies were unable to fully pass on the soaring input costs, particularly those of key metals and energy, in 2021.

The broad-based recovery expected in the next fiscal will facilitate the pass-through of input costs to end-consumers and keep core inflation high. It is notable that while overall consumer inflation came down to 5.2 per cent in April-December 2021 from 6.6 per cent during the same period in the preceding year, core inflation (which excludes energy and food) went up to 5.9 per cent from 5.4 per cent.

This fiscal, in contrast to global trends, low domestic food inflation has dragged the overall inflation down. This trend could continue if monsoons are normal this year. After six consecutive normal/near-normal monsoons, the chances of a monsoon failure increase, statistically speaking.

Due to heightened uncertainty, the monetary policy will largely remain data-driven. The RBI will have to keep its eyes peeled for price trends, which have, so far, surprised on the upside in many economies.

Joshi is chief economist, CRISIL Ltd