rbi: Monetary Policy Preview: Is the RBI Trailing the Fed?

Over the past few meetings, the Monetary Policy Committee (MPC) has repeatedly highlighted the uneven and fragile economic recovery as the main reason behind unchanged monetary policy decisions and guidance. The justification for the need for benign conditions and a pro-growth orientation has arisen against the background of MPC continue to provide a more conservative future path for inflation.

As a reminder, the policy backdrop of February 2022 also faced a clearly unfavorable global environment, in which the main central banks of developed countries had either started to hike interest rates (BoE) or the guidelines for aggressive rate hikes were postponed in the forthcoming meetings (fed). Inflationary risks were further fueled by the nearly 20% surge in crude oil prices in the first month of 2022. Global yields have risen since the start of fiscal 2022 as market expectations point to an aggressive tightening of financial conditions to deal with global inflationary pressures.

The effects were massively visible FPI Outflows from India ($15.7bn) in 4QFY22. However, the MPC preferred to focus on domestic factors Reserve Bank of India (RBI’s) 2HFY23 inflation forecasts were expected to trend towards 4%. Notably, the market consensus was too high (50-75 basis points) out RBI‘s forecast of 4.5% for fiscal 2023.

The situation has only worsened since the February 2022 meeting. The Fed highlighted rate hikes of nearly 200 basis points in fiscal 2022 and tensions between Russia and Ukraine, further exacerbating supply-demand imbalances across the commodity spectrum and having a significant impact on the Indian economy. Crude oil prices have averaged $110 per barrel since the conflict (up 44% in Q4 2022), nearly $35 per barrel above the April-December 2021 average.

Inflationary pressures are becoming more general as input costs rise across the board. Following the onset of fuel price hikes, various Indian companies across sectors (consumer goods and construction) have started to pass higher input prices on to consumers (albeit in part given the still tepid pricing power) to avoid a significant impact on margins. In February, 51% of the CPI basket had inflation above the RBI’s 6% ceiling (vs. 33% pre-pandemic).

Going forward, the pass-through of higher input prices is expected to further weigh on the general nature of inflation developments. So far, discussions and opinions on policy decisions have been partly aided by the flexibility of the MPC’s inflation mandate to keep inflation below 6% (even if it remains above the MPC’s 4% medium-term target), and thus the scope for the support of growth .

We expect headline inflation to stay above 6% for the next 4-5 months before moderating in 2HFY23 (average 1HFY23: 6.4% and 2HFY23: 5.2%).

As inflation risks become heavily skewed to the upside, the challenge for the RBI is further compounded as inflation triggered by the commodity shock is expected to weigh heavily on growth. We expect FY2023 GDP growth of 7.5% (up from 8.1% previously and RBI of 7.8%) with further downside risks.

Such growth risks will continue to prompt government sectoral support to protect consumers and farmers (through tax cuts on fuel and cooking oils, higher allocations for fertilizer and food subsidies, and MNREGA) from adverse shocks. This could further depress sentiment in bond markets, which already remains weighed down by expected plenty of supply, elevated global yields and higher inflation, which is beginning to risk monetary tightening sooner than expected.

At the start of the year, we expected the final fiscal 2023 budget results (6% vs 6.4% BE) and hence bond supply to be lower than announced throughout the year union budget (given the conservative tax assumptions) these cushions will soon dwindle.

Fixed income markets have behaved reasonably well in recent months given the lack of supply despite adverse conditions. However, with fresh supply entering the market from next week, the forthcoming policy in dealing with Forward Guidance requires RBI to be very cautious both in exit policy and in managing the government’s heavy borrowing program.

Given the RBI’s stated stance on an orderly development of the yield curve and smooth government debt, it will have to take concrete measures to avoid disruption in the bond markets. In a policy turning cycle, the RBI’s ability to aggressively support the bond market through OMO purchases remains limited. However, with crude oil prices and FPI outflows this high, the huge negative balance of payments could provide a decent window for OMO buying, but the magnitude and timing cannot be determined given the uncertainty.

The bond markets will only be consoled with clear support from politicians, since demand-supply dynamics remain heavily distorted. Overall, our estimates suggest that the RBI will need to support the bond market through OMO purchases or OTs with almost Rs 4-5 trillion to handle the large supply.

On the policy front, the MPC should recognize that even where inflation is supply-driven, accommodative monetary policy needs to return to normal quickly to avert a vicious spiral of elevated inflation over the medium term. First, the accommodative political stance must transition to a neutral one as normality of the political corridor is restored. While we firmly believe that this adjustment should happen as soon as possible, the recent negative sentiment and downside risks to growth will once again highlight the divergence between what the MPC should do and what it will do.

Weighing the known and the unknown, the MPC will prefer to reiterate its pro-growth focus and maintain the status quo on rates and the accommodative stance at the upcoming meeting. However, the MPC must acknowledge the risk of inflation exceeding 6% for a few months in the near term, warranting an upward revision to its already muted 4.5% forecast for fiscal 2023.

For now, markets will be keen to get clarity on the MPC’s exit policy and guidance on how and when the operating target rate (under the MPC framework) will be reset back to the 4% repo rate (regardless to the contrary). repo increase, the RBI may perform overnight VRR/VRRRs to achieve this goal). rbi: Monetary Policy Preview: Is the RBI Trailing the Fed?

Adam Bradshaw

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