To paraphrase Duran Duran’s 1993 hit single Come Undone in the current context of rising inflation:
Who do you heed (some think more rapid inflation is temporary; others worry it is long-lasting),
Where do you run (rate hikes could hurt the recovery; rate cuts could make it unsustainable),
When you come undone
Inflationary pressures are on the rise, globally and domestically. Amid the debate about whether global price pressures are temporary or permanent, two domestic shifts are worth noting. Real rates in India have moved into the negative terrain and some measures of inflation expectations have begun to rise gently.
Inflationary pressures in India are best measured on three levels: the wholesale price index (WPI), intermediate costs— logistics, transportation and profit margins—and the consumer price index (CPI). WPI inflation was subdued last year during the first wave of the pandemic due to falling global commodity prices, but inflationary pressures were rife at the intermediate cost and CPI inflation level, led by logistical and transportation bottlenecks.
This year is different, as inflationary pressures have surfaced in the WPI. And within WPI inflation, input prices are rising much faster than WPI output prices. Interestingly, the same trends are visible in the purchasing managers’ indices (PMIs): input prices are rising faster than output prices.
Producers do not seem to be passing on much of the rise in raw material costs to output prices, perhaps worried that already uncertain demand could weaken further. Traditionally, 60% of price pressures tend to be passed on to consumers, but this time, it has fallen by half, with the rest being taken as a hit to companies’ profit margins.
What does this mean for inflation? There are signs that the second wave of the pandemic has peaked and some states are considering steps to roll back local lockdowns. As demand for goods and services gradually picks up, producers may feel more confident about passing on raw material cost increases to output prices, pushing core inflation higher, particularly in the second half of FY22.
Will RBI be able to respond? Last year, RBI was faced with conflicting objectives on inflation, bond yields and the rupee, also known as the impossible trinity. It bought dollars to prevent the rupee from strengthening too much and purchased government bonds to keep bond yields from spiralling out of control. But this created excess rupee liquidity in the banking system, which over time can stoke inflation and other financial imbalances. These conflicting objectives are also likely to linger this year, and RBI will have to juggle them carefully.
Yet, as the year progresses, space could open up for RBI to gradually shift the focus to inflation control. With the current account moving into deficit, we expect the balance of payments surplus to fall, so RBI may not have to purchase as many dollars as last year. The resultant cap in domestic liquidity could become an important part of the normalization of monetary policy and inflation control.
Having said that, RBI would still need to buy government bonds to support the administration’s borrowing programme; and there are risks that the second wave of the pandemic will raise the fiscal deficit, leading to more supply of bonds. However, we think a large carry-over of cash balances could act as a buffer—they totalled ₹2.5 trillion at the end of FY21, almost double the recent average. This could help fund some of the unbudgeted rise in the fiscal deficit.
All told, if the need to buy dollars is lower than last year, RBI could gradually shift the focus to controlling inflation and plan a gradual exit from loose monetary policy.
But how would that unfold? Starting in 4Q 2021, when the proportion of the population vaccinated will hopefully reach critical mass, we expect RBI to start reducing the level of surplus liquidity, raise the reverse repo rate, and change its monetary stance to neutral. We think the aim should be to gradually push up short-end rates towards 4%, so that real rates don’t remain hugely negative for too long.
Having said that, we think that an increase in the benchmark repo rate— currently 4%— can wait, perhaps until there are surer signs that the private investment cycle is rising.
At the policy meeting on 4 June, RBI may want to keep rates and stance unchanged given that the number of coronavirus cases are still high. It could announce the next tranche of its government bond-buying programme, and markdown its GDP growth forecast from the current 10.5%.
There are likely to be a few regulatory steps in the June mix. But several have already been announced recently, and new steps may not have the same bang for the buck. Instead, we think government policy would do well to focus on the growth objective from this point onwards.
Pranjul Bhandari is chief India economist at HSBC
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