RBI’s change in stance imminent

Declining global economic growth and accelerating inflation were expected even before the start of the Russia-Ukraine conflict. The conflict has only worsened the growth-inflation matrix and raised the specter of dire financial conditions. Not only that, S&P Global is forecasting a global growth rate of 3.6% in 2022, 60 basis points lower than the December forecast. And it has slashed US GDP growth by 70 basis points to 3.2%.

Still, inflationary pressures have forced the US Federal Reserve, the systematically most important central bank, to go on an aggressive rate hike path this year. Europe is also moving ahead with its tight circle. Several other emerging markets have also raised interest rates over the past year.

The Asian story has been somewhat different, with several central banks including the Reserve Bank of India (RBI) looking at inflationary pressures to propel growth. Lately, we have seen some of them defying road expectations on the dial-back of an accommodative stance. But interest rates are expected to rise in most Asian economies, as it will be difficult for central banks to ignore inflationary pressures.

The economic context has changed dramatically since the last review by the RBI’s Monetary Policy Committee in February. Omicron-type risks, which proved to be mild, have been quickly replaced by geopolitical risks. The fiscal year 2023 was based on retail inflation at 4%, with the second half printing to 4.5% of retail inflation. But given the spurt in crude oil and commodity prices following the Russia-Ukraine conflict, this scenario is unlikely to play out.

We expect the RBI to change its stance from ‘accommodative’ to ‘neutral’ on April 8 after its monetary policy review. This will provide flexibility to move in any direction later.

We also see that the RBI is moving towards normalizing the policy-rate corridor (the difference between the repo and reverse repo rates) by increasing the reverse repo rate by 25 basis points. This will be insignificant as the call money rates have already strengthened and are now close to the reverse repo rate.

This will prepare the market for a hike in the repo rate, which we expect to be 50-75 basis points in fiscal year 2023, starting with the June monetary policy review. This is necessary to mitigate the risk of de-anchoring the already high inflationary expectations.

Here’s why:

In the base case, CRISIL expects average consumer price index (CPI) based inflation to remain stable at 5.4% in FY2023 if crude oil prices average $85-90 per barrel. Inflation risks are strongly upward sloping, especially if the current geopolitical conflict is prolonged.

It is true that inflation is largely supply driven as demand remains weak. Private consumption demand remains the slowest growing component of GDP. But supply shocks no longer seem momentary. Rather, they are becoming more frequent. What started as a gradual rise in commodity and crude oil prices in 2021 has now intensified, and it will be difficult for the RBI to ignore these developments.

The pressure on core inflation, which remains in the range of 5.5-6.0%, has not eased despite weak demand. This may increase as input costs continue to rise.

WPI inflation for non-food items, a proxy indicator of input costs, stood at 15% in February.

IIM Ahmedabad’s recent Business Inflation Expectations Survey showed that a year ahead, business inflation expected in January 2022 rose to 6.0% from 5.45% in December 2021. This is the fastest increase since 2017 when the survey was launched. Companies are incurring these costs to end consumers wherever they can. Additionally, services inflation, which has lagged behind goods inflation so far, is expected to rise as connectivity-based services rebound.

In the financial year 2021-22, relatively low food inflation with a weighting of over 40% in the Consumer Price Index kept a lid on overall inflation. While Skymet and the Indian Meteorological Department (IMD) have predicted a fourth consecutive normal monsoon this season, prices of agricultural inputs from fertilizers to pesticides have increased, and prices of wheat and maize have started rising.

And finally, household inflation expectations, which moderated slightly in the RBI’s January survey, are set to strengthen again.

Since supply shocks are better controlled through fiscal policy, we should expect tariff cuts on commodities, and especially crude oil, if the Russia-Ukraine conflict and its subsequent effects are prolonged. Huh.

(Dharmkirti Joshi is the Chief Economist, CRISIL Ltd. Views are personal.)