Why the RBI must not take its eyes off inflation yet

Shaktikanta Das, Governor of the Reserve Bank of India. After watching inflation soar for many months, India’s central bank stepped in to raise rates and bring the runaway inflation under control. Image: Anshuman Poyrekar/Hindustan Times via Getty Images

In its July bulletin, the Reserve Bank of India hinted that inflation could peak and come within the 2-6% tolerance range by the fourth quarter of the current fiscal year. This is the central bank’s baseline scenario. On a more optimistic note, the RBI is not ruling out the possibility that “the slowdown in inflation could be even faster and faster”. The key is the direction of inflation change – not its level – in these extraordinary times, he said.

However, economists warn that inflationary risks cannot be minimized at this stage. The central bank needs to focus on measures to get inflation under control, despite CPI and WPI inflation figures falling month-on-month (see chart) and falling 20 to 40% of world commodity prices. On the contrary, the recent decline in input prices may help the RBI bring inflation down to 6% by March next year, if it continues to tighten rates.

Why the RBI must not take its eyes off inflation yet
After watching inflation soar for many months, India’s central bank stepped in to raise rates and bring the runaway inflation under control. During two tightening measures in May and June, the Reserve Bank of India raised the benchmark rate by a cumulative 90 basis points to 4.9%. As the Reserve Bank’s rate-setting panel prepares to meet on August 3 to adjust interest rates, most economists expect the repo rate to rise 25-50 basis points .

US Fed: series of rate hikes

At its July meeting, the US Federal Reserve raised rates by 75 basis points for the second consecutive time (see chart). The policy rate is now close to its long-term estimate of 2.5%. He admitted that recent spending and output indicators have weakened, but with inflation at 9.1% (see chart), the US Federal Reserve has its work cut out as it seeks to bring back the inflation at 2%. In his own words, the risk of over-tightening in the short term is less than the risk of under-tightening. Why the RBI must not take its eyes off inflation yet“The RBI will remain focused on suppressing domestic inflation in August policy. Absent any surprises from the Fed, we expect the RBI to remain on track to raise the rate. repo by 35 basis points while maintaining a hawkish stance,” says Suvodeep Rakshit, Senior Economist, Kotak Institutional Equities.

Economists and analysts expect the US Fed to hike rates 50 basis points in September, followed by a 25 basis point hike in November and December. Most economists expect the US economy to slip into a mild recession later this year. The Fed’s emphasis on the inflation mandate with a series of rate hikes on the horizon also raises concerns for the domestic economy.

Why the RBI must not take its eyes off inflation yet

Core inflation: No respite yet

On the face of it, inflation has moderated with a downward trend in retail and wholesale price inflation over the past two months. Yet core inflation (excluding food and fuel) remains stable at over 6%, suggesting that it may be difficult to contain headline inflation below 6% given the volatility of the economy. food and fuel supply. Extreme weather conditions and changing sowing and seasonal patterns due to climate change make it more difficult to predict food and energy prices and therefore accurate inflation forecasts are difficult. Why the RBI must not take its eyes off inflation yetFurthermore, economists say that inflation in India tends to be sticky and that since the pandemic big business has gained pricing power and may start passing on rising input costs to consumers. HSBC India chief economist Pranjul Bhandari said the RBI may need to do more to anchor inflation expectations. “For example, it may need to experiment with new techniques like raising rates earlier rather than later in the cycle, to keep inflation expectations anchored without too much cumulative tightening,” she notes.

The angle of the rupee

Decades-high levels of inflation in developed economies, coupled with steep rate hikes by central banks, are fueling fears of a global recession. This has contributed to lower commodity prices which has lightened India’s import bill, but also increases the likelihood of lower demand from other countries for Indian exports. Also Read: As Rupee Falls, Indian Importers Have No Choice But To Stay Nimble

Economists expect India’s balance of payments to turn into a deficit this year. This will further weaken the Indian rupee, which recently hit a new low above 80 against the greenback. The RBI’s intervention cushioned the impact, but the central bank’s foreign exchange reserves fell to a 20-month low of over $572 billion.

Why the RBI must not take its eyes off inflation yetIn a situation where the balance of payments is in deficit and the US dollar continues to climb against the Indian rupee, the RBI estimates that CPI inflation could potentially increase by 20 basis points for every 5% depreciation. of the INR.

“While the Fed’s moves fueled INR weakness against the dollar, the RBI used its foreign exchange reserves to weather the resulting volatility. We believe a 35 basis point rise with a hawkish stance will be appropriate. Arguably, the choice is finely balanced between a 35 basis point hike and a 50 basis point hike in August policy,” Rakshit says.

The best strategy for the Reserve Bank, in this context, would be to take steps to keep the Indian rupee competitive. More importantly, the MPC needs to buy into raising rates to fight inflation.

Read also: All is not well in the economy, say the most optimistic soothsayers

“We believe that the RBI should raise the repo rate to 6% by December this year, raising rates at each of the remaining three policy meetings in 2022. And raise again up to 50 bps. basis in 2023 depending on the inflation situation,” Bhandari adds.

Focus: MPC meeting in August

The strict mandate of the RBI MPC is to control inflation between 2 and 6%. However, in recent months inflation has been outside this range. Until April, RBI Governor Shaktikanta Das had been clear on the central bank’s motivation to support a sustainable recovery in the economy. Growth has admittedly taken a step back over the past two months as the MPC rushes to douse the flames of runaway inflation. At its last meeting, the MPC reduced its GDP estimate and raised its inflation projection (see table) for the current fiscal year. Why the RBI must not take its eyes off inflation yetAt the August meeting, analysts and economists do not expect a revision of growth and inflation forecasts. Most economists see a 35 basis point rate hike as a base case scenario, but don’t rule out the possibility of a smaller 25 basis point rate cut or a steeper 50 basis point rate cut. basis points.

Bank of America revised up its previous call for a rate hike by 25 basis points to 35 basis points, and the global brokerage firm expects a shift in stance from pulling back from accommodation to a calibrated tightening. The call for a higher rate hike is motivated by the sharp depreciation of the rupee by 2.6% and the negative evolution of the balance of payments. The persistently high trade deficit and relentless outflows of FII shares suggest the rupiah may weaken further to 82 to the dollar by December. Additionally, the US Fed’s aggressive rate hike of 75 basis points for the second time adds pressure on the MPC to raise rates.

Indian economist Aastha Gudwani said: “If the RBI MPC decides to send a more decisive signal, then it can continue with strong rate hikes, raising the repo rate by 50 basis points in August. In this case, the position could switch to a tightening and the repo could be increased to 5.9% by March.

Explaining the other possible scenario of a 25 basis point rate hike, Gudwani adds: “If the RBI MPC decides to resort to a more measured 25 basis point hike, citing downside risks to their inflation forecast CPI of 6.7 percent yoy, so the repo rate could go to 5.65 percent by March. In this case, we see the position change to calibrated tightening.

Pankaj Pathak, fund manager, Quantum Mutual Fund, expects the RBI’s comment to soften a bit with an acknowledgment of receding inflationary risks. In August policy, investors will be looking for clues about future rate hikes in this cycle.

“From a bond market perspective, a lot of this is already priced in, as bond yields have fallen more than 25 basis points from their recent peak. Indian bond yields are likely to trade in a narrow range over the coming months,” adds Pathak.

Read also: Asia: Are you looking the US recession in the eye?

Overall, economists are unanimous in saying that the RBI’s inflation forecast of 6.7% for the current fiscal year is an underestimate. Aurodeep Nandi, VP and Indian Economist at Nomura, says: “The RBI strategy should be driven by the path of inflation. We believe RBI’s current projection of 6.7% for FY23 inflation is still underestimated. We see inflation around 7.5 percent. Inflation in India is a problem, which means RBI will have to rise more. Our terminal rate projection is 6.25%. »

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