Headline inflation is set for a steady rise, but the RBI, it appears, has bet the farm on it being temporary and kept key benchmark rates unchanged on Friday.
Inflation projections are raised upwards by 60 bps (0.6%) at 5.7% for FY22, but citing 'optimism over gloom,' the central bank decided to go after 'nascent, hesitant recovery.'
In June too, RBI termed inflation was transitory, but in the end it missed its own forecasts in Q1 by 40 bps (0.4%). As if poking on the sore spot, inflation may remain dangerously close to the upper tolerance band, not just this fiscal but also in the first quarter of next fiscal.
If in Q2, it may touch 5.9%, in Q3 and Q4, it's likely to settle at 5.3% and 5.8% respectively. However, price rise may ease to 5.1% in Q1, FY23. But that's 110 bps (1.1%) above RBI's stated 4% mandate.
Although the recent (high) inflationary pressures are evoking concerns, the six-member Monetary Policy Committee (MPC) unanimously voted to maintain status quo, prioritizing growth over rising prices. Repo rate and reverse repo rate stand at 4% and 3.35% respectively.
By the RBI's own admission, both inflation and inflationary expectations were well anchored at 4% pre-Covid. Clearly, it's now out of hand, thanks to volatile crude oil prices and subsequent high logistics costs, elevated prices of industrial raw materials and demand-supply mismatches. But the MPC decided to look through all these citing exogenous factors and temporary supply-side disruptions.
In any case, since the onset of the pandemic, the MPC has prioritzed growth revival and given the slack in the economy. Governor Shaktikanta Das stressed that a pre-emptive monetary policy response may kill the nascent and hesitant recovery.
Channelling Mahatma Gandhi, he quoted: "I am an irrepressible optimist, but I always base my optimism on solid facts."
Do we have solid facts?
According to Das, all three high frequency indicators -- consumption (government and private), investment and external demand -- are gaining traction, yet real GDP projections remained unchanged at 9.5% for this fiscal.
The good news though is the upward revision in Q1 output at 21.4% from 18.5% projected in June. It means, the impact of April-May lockdowns and curfews is likely to be rather limited than previous estimates. But growth is expected to settle down to 7.4%, 6.3% and 6.1% in Q2, Q3, and Q4 respectively. It's expected to rise by 17.2% in Q1, FY23.
The central bank's read on the economy indicates robust outlook for agriculture and rural demand will support private consumption. Data on auto sales, electricity consumption, non-oil, non-gold imports, consumer durable sales and hiring of urban workers bear testimony to early signs of economic recovery. Futher, RBI's surveys suggest one-year-ahead sentiments returning to optimistics territory from historic lows, even as corporates are exhibiting healthy growth in sales, wage growth and profitability. Some even expect expansion in production volumes and new orders boding well for investment.
That said, global commodity prices, episodes of financial market volatility and vulnerability to new waves of infections are downside risks to economic activity.
Coming to liquidity, Das re-introduced the variable rate reverse repo (VRRR) auctions worth Rs 13 lakh crore from now till September. He, however, warned that these auctions shouldn't be misread as a reversal of the accommodative policy stance, as the amount absorbed under the fixed rate reverse repo will remain over Rs 4 lakh crore by end of September.
Citing the need for active trading across all government securities, Das reiterated that orderly evolution of the yield curve was a public good and that both market participants and RBI has a shared responsibility. He added that the government's decision to accommodate GST compensation to states from existing cash balances should assuage market concerns on the size of government borrowing programme this year.
Meanwhile, analysts believe liquidity normalisation is already underway with RBI taking small steps to pull back the extraordinary level of liquidity. The past six months' data shows notable evidence. From a high of Rs 6.8 lakh crore in December 2020, system liquidity fell to Rs 5.5-6 lakh crore currently. Barclays' noted that the rise in liquidity in June-July indicates RBI's ‘passive strategy,' allowing organic factors like currency in circulation to slowly drain liquidity surplus overtime.
For now, two questions are drawing attention: When will RBI start exiting its highly accommodative monetary policy stance and how will it sequence it?
"Through the past 18 months, the RBI has consistently surprised the market to the dovish side. In particular, Das has intervened at key moments to temper market pricing of an early policy exit, reiterating the RBI’s commitment to maintain its growth supporting bias, even if at the expense of (temporarily) higher inflation, in our view," Barclays noted last month.
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