All members of the RBI’s MPC decided to keep the policy rate and its stance unchanged (5 to 1 majority), with the focus being on growth revival as long as necessary to revive and sustain growth on a durable basis and continue to mitigate the impact of COVID-19 on the economy, while ensuring that inflation remains within the target going forward.
The focus continues to be on growth revival as the economy is not completely out of woods. The GDP (Q1 2021-22) is down 15% when measured from the level of GDP recorded pre-pandemic (Q4 of 2019-20). Lately, headline inflation has seen some moderation with improving supply conditions. However, core inflation remains sticky at 5.8%. Persistent high inflation could diminish the purchasing power and impact consumption demand. The recent data indicates this with consumer spending shifting more towards fuel from other non-discretionary items. The pass-through effects of higher fuel prices (up ~55% compared to last year), include higher transportation costs and consumer prices. Also, high inflation lowers the relative real rate attractiveness among EM peers (Brazil and Russia have hiked rates by 325 and 250 basis points, respectively) which could lead to FPI outflows from the debt market. Further moderation in core inflation with improving supply conditions should give room to the RBI to maintain a growth supportive stance. The headline inflation projection for FY 2022 is tonned down to 5.3% from 5.7% projected earlier with risks broadly balanced, drawing comfort from the downward trajectory of food inflation. The MPC also flagged concerns around high crude oil & commodity prices along with shortage of key industrial components (semi-conductors, etc.) and high logistics costs on input costs. The pass through of these costs to end consumer prices has been limited to weak demand conditions.
On the growth front, the real GDP projection for FY 2022 is retained at 9.5%. High-frequency lead indicators suggest month-on-month improvement across segments in Q2, following a second wave-led dip in Q1 of FY 2022. Indian manufacturers signaled growth pickup as demand outlook improved. The services PMI continued to expand in September supported by improvement in overall demand. Auto sales are seeing month-on-month improvement, although still lower than the pre-covid levels. Both direct and indirect tax collection numbers continue to show strong growth. The formal sector unemployment rate has stabilized around pre-covid levels. RBI’s survey shows businesses plan to expand production volumes as they expect a pick-up in new orders. Other lead indicators (fuel and power consumption, e-way bills, etc.) also show improvement in business activity. However, much of the near-term growth outlook is dependent on the progress of the vaccination coverage, which is progressing well with ~26% of the adult population fully vaccinated, and the pandemic control amidst the start of the festive season.
The household sector has seen a rise in debt levels as the second wave did impact the earning capacity. Additional direct fiscal boost (MGNREGA) by the government to improve disposable income should help in reviving consumption demand on a durable basis. Strong external demand is an opportunity for India and further policy support should help in capitalizing on this. The PLI (Production Linked Incentive) scheme to boost local manufacturing is a step in the right direction. Also, the government’s focus on capital expenditure bodes well for the investment cycle which started to gain momentum. This along with the recently launched NMP (National Monetisation Pipeline) should give a boost to capital formation and infrastructure development.
We are around the turning point of the current low-interest rate cycle. Bond investors should anchor their return expectations as return from bonds would be a lot more normalized over the next year or so as compared to returns delivered in the last two years. The shorter end of the yield curve could flatten in the near term with further normalization in the banking system liquidity. The variable rate reverse repo auctions should have minimal impact on the overnight rates as they are conducted for better liquidity management and shouldn’t be interpreted as a reversal in accomodative stance. Based on MPC’s evaluation of the liquidity situation, the G-SAP operations will be put on hold for now given existing liquidity overhang (Rs 9.5 lakh crores of surplus liquidity). The medium-to-long-term segment of the G-sec yield curve is firming up with a rise in crude oil prices and US treasury bond yields. However, the RBI stands ready to undertake G-SAP and deploy other tools such as OMOs and Operation Twist to keep yields under check.
The coming months will make it more challenging for the RBI to navigate the inflation concerns amid the risk of a third wave, resultant supply shocks, and pass-through effects of high fuel & commodity prices on core inflation. Nonetheless, the RBI is expected to maintain the status quo on policy rates for this financial year to prioritize growth over inflation. Any reversal in the policy stance would be gradual and calibrated in nature.
