By Suvodeep Rakshit
Global and domestic macro conditions have changed substantially since the RBI MPC meeting in early-February. The geo-political situation has deteriorated with the Russia-Ukraine war. Resultant production disruptions in key commodities and food articles have increased headwinds for the global economy. Since the last meeting, crude oil price has increased nearly 15% to average around US$110/bbl over the last couple of months with significantly higher volatility. The US Fed has become much more hawkish (indicating 175-200 bps of rate hikes in CY2022) which is reflected in the 2-year and 10-year UST yields increasing by close to 100 and 60 bps since the last RBI policy.
On the domestic front, OMCs have started raising fuel prices and petrol and diesel prices have increased around 10% since the last policy meeting (and due for more increases). The 10-year yield has increased by around 20 bps to above 6.9%.
The RBI MPC had estimated average inflation of 4.5% in FY2023 in the February policy. While this was much lower than what markets were expecting, the consensus estimates have increased since. The inflationary pressures have become more generalized given the broad-based surge in input costs. In February, 51% of the CPI basket had inflation higher than RBI’s upper threshold limit of 6% (compared to 33% pre-pandemic). Inflation outlook remains biased on the upside with (1) greater chances of global commodity prices across crude, edible oil, metals, etc. staying high, (2) raw material price inflation yet to pass-through into retail prices, and (3) impact of higher domestic fuel prices across primary and manufactured products. The RBI will have to revise its estimates higher though it may continue to pin it on supply-side driven factors which, till now, they have preferred to look through. We expect inflation around the 6% mark over the next few months and average at 6.4% in 1HFY23E and 5.2% in 2HFY23E—a strong case to signal the need to reverse pandemic excesses.
Given the uneven growth recovery that is underway it is likely that it will continue to be a concern for the RBI. Markets are also shifting to a view of a possible US recession given the waning fiscal impulses and rapid normalization of monetary policy and Fed’s balance sheet. On the domestic front, private consumption and contact-based services remain below pre-pandemic level. RBI’s surveys on consumer confidence while improving have remained subdued. Capacity utilization remains below 70%. However, there has been some pickup in credit growth, especially from the industry side. The RBI needs to take this into cognizance when deciding on the liquidity normalization path. Excess system liquidity in a credit growth pick up phase could be a potential macro-prudential risk. With uncertainties on the global front, and a nascent recovery in some of the services sector, the RBI will likely remain cautious on growth prospects and maintain pro-growth conditions.
With another large government borrowing calendar to be placed through 1HFY23, the RBI will have its hands full. With fresh supply hitting the market from this week, RBI will have to move cautiously in the April policy. In the policy reversal cycle, there will be limited ability of the RBI to support the bond markets through OMO purchases. Our estimates of the government market borrowings’ demand-supply dynamics indicate that the RBI may have to support the markets to the tune of Rs4-5 tn which will be difficult in a policy reversal phase. The RBI may get a window to support domestic liquidity given the expected large negative balance of payments though the quantum and timing cannot be pre-decided. In the April policy, it will need to balance between the guidance for the exit policy from the pandemic excesses and the management of the government’s heavy borrowing program.
In the April policy, the RBI MPC will likely restate its pro-growth focus and maintain status quo on rates and accommodative stance. However, the MPC should acknowledge that inflation is a concern even though it remains supply-led. Along with revising up its inflation estimates it should prepare the markets by telegraphing its intent in normalizing policy opportunistically. While a good measure to signal intent could be to hike the reverse repo rate to 3.75%, the RBI could possibly hold back on that too. Though we note that even if it were to hike the reverse repo rate, it is unlikely to affect the markets since effective rates are much higher. The RBI and the MPC, even if without any change in decisions, should use the April policy to shape expectations for an imminent turn in the policy cycle and providing adequate time for the markets to absorb any shocks.
(Suvodeep Rakshit is Senior Economist in Kotak Institutional Equities. Views expressed are the author’s own.)
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