RBI monetary policy: Dovish stance may continue till August before normalization kicks off

Dr. Esha Khanna | Updated on: Friday, April 08, 2022, 11:30 PM IST


Mumbai: Inflation is becoming more generalized nowadays as supply-side pressure still remains due to spiralling oil and commodity prices, supply chain disruptions, increasing freight charges, and geopolitical uncertainty. It is still unknown how long these elevated prices in oil and metals will continue amid prolonging Russia- Ukraine crisis. A short-term resolution through monetary policy support may be correct at this juncture as these current inflationary pressures might turn out to be a temporary shock.

On the domestic front, the sustained inflationary pressures have not caused upward revision in wages and rentals; and companies have not used their pricing power to pass on the input cost pressure to consumers preventing the long-run consequences of spiralling inflation. However, if the current trend prevails for some more time, producers intended to pass on the input cost pressure to consumers will soon reflect on retail CPI. Core inflation, however, continues to remain elevated due to high food prices and global spill overs on a continuous basis.

The demand side recovery is still is in the early stage. Though with fear of the pandemic withering out and the economy is no longer hostage to the Covid-19 pandemic, there are offshoots. But advance estimates by NSO show that private final consumption expenditure as a percent of GDP though is likely to increase, but still be below the pre-pandemic levels of 2019-20. Other urban demand indicators such as passenger vehicles, two-wheelers, and consumer durables present a piece of the mixed evidence. Another steer to durable growth, gross fixed capital formation remains feeble recording a 2 percent year-on-year rise along with the mild improvement in the current situation, showed the Index on Consumer Confidence Survey released by the RBI on 10th February 2022. The Survey reiterates the need for a sustained focus on increasing demand and reversing the prolonged slowdown in private investment and consumption.

Heightened risk emanating from the geopolitical situation can be witnessed in the decline in Purchasing Managers Index which fell to 54 points in March compared to 54.8 points in February. Manufacturers have reported dampened business confidence owing to elevation in input cost and the supply-side pressure. These inflationary pressures are likely to translate into increased consumer prices albeit with a lag that can have a further dampening effect on demand.

Also, monetary policy as a tool for rebalancing inflation may be more effective when there is an existence of demand-pull pressures than supply-side constraints. Issues like geopolitical tensions, persistent supply chain disruptions, increasing freight charges, and continued dependence on monsoons cannot be directly resolved by monetary policy action. Inflation-growth trade-off dynamics may prove to be correct in this case of supply-driven shock. The goal of higher growth and low inflation may not be achieved simultaneously. It may be wiser at this stage to accept a slightly higher price level with elevated outputs than to sacrifice output levels to see reduced inflation.

Another worry that emanates from the central banks across the world is their rapidly turning hawkish stance. The easy money policy being tapered down, has triggered a bigger concern putting RBI already behind the curve. The first line of spill over effects were visible with FPI pulling out amounting to Rs 79,000 crore from financial sector equities, and the selling spree continues owing to tightening interest rate by the US, heightened geopolitical risk, and higher valuation of Indian stocks.

However, RBI may continue to follow a divergent path as India continues to receive a rising share of foreign direct investment alongside strong exports touching an all-time high of the $400 billion mark with a growth of 25.1 percent. Additional strength comes from the compositional shift in India’s profile of external debt and foreign exchange reserves holdings. One of the lowest external debt among emerging markets and the fifth largest holdings of foreign exchange reserves in the world provides a cushion against external spill overs and make the external sector more resilient. On the brighter side, the withdrawal of FPIs creates more room for government borrowing and easier to rebalance the liquidity position within the existing framework of current policy rates. Additionally, given India’s structural appeal among emerging markets and strong growth prospects, this trend will reverse once again in equity markets.

Fiscal space has a crucial impact on bond yields. As union government announced its plans to borrow Rs 8.45 lakh crore, in the first half of FY2022-23 i.e. 60 percent of total gross market borrowing of Rs 14.31 lakh crore estimated for FY2022-23. It is likely to harden the bond yields and investors re-allocating from equity to debt. So far, RBI has engaged in massive OMOs and committed to a large-scale buying of bonds in order to ensure orderly evolution of yield curve. Emerging market scenarios have already limited the Central bank’s capacity as a buyer when other counterparts are turning sellers. Moreover, monetary and fiscal coordination is crucial at this juncture to crowd in private investment.

The global financial volatility, elevated crude oil prices knocking off the GDP, muted global demand due to rising inflation, and supply chain disruptions are all warranting RBI to take a tougher path on monetary policy guidance and change its stance to neutral.

• RBI is likely to take a calibrated approach and continue to rebalance liquidity through measures viz. VRRRs and reversal of CRR cut.

• Likely to keep repo rate unchanged at 4 percent during its bi-monthly monetary policy review on Friday.

• May consider a hike in the reverse repo rate by 15-25 bps to the extent that narrows the policy corridor reducing the volatility of market rates.

We believe, domestic macro-economic factors will continue to be an anchor for monetary policy guidance and the central bank may stay accommodative stance to sustain demand on a durable basis as downside risk still prevails.

Dr. Esha Khanna, Assistant Professor, NMIMS Sarla Anil Modi School of Economics

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Published on: Friday, April 08, 2022, 09:38 PM IST