Inflation Outlook: RBI Status Quo on Omicron Uncertainty
The Monetary Policy Committee (MPC) is meeting next week amid renewed uncertainty generated by the Omicron variant of Covid-19. At its last meeting, in October 2021, it noticed that with production below the pre-pandemic level, the recovery remains uneven and depends on continued political support. With T2FY22 GDP slightly above the pre-Covid-19 level, will the MPC conclude that the economic recovery is broad and sustainable enough, and that political support can be weaned? Unlikely, in our opinion.
As a reminder, the October policy review did not hold any major surprises. The MPC voted unanimously to maintain the key pension rate at 4%. In a split vote, he said he would maintain the accommodative position for as long as needed to revive and support growth and continue to mitigate the impact of Covid-19 on the economy, while ensuring that the inflation remains on target for the future. The MPC had kept its growth forecast for FY22 at 9.5%, fixing the expansion of T2FY22 at 7.9%, while reducing its inflation forecast for this year by 40 basis points to 5.3. %. As expected, the RBI simultaneously refrained from raising the reverse repo rate, while continuing to move towards liquidity normalization.
Recent macroeconomic developments are decidedly mixed, both on the inflation and growth front. Encouragingly, CPI inflation fell from 5.3% in August 2021 to 4.3% in September 2021, before rising slightly to 4.5% in October 2021. The Center announced a cut in excise duties welcome on gasoline and diesel, followed by a reduction in VAT on the latter several states. The softening effect of this development should be visible in the underlying CPI inflation for November 2021.
In addition, the outlook for the rabi crops is good, which softens the expected food inflation trajectory. Benefiting from healthy moisture levels, the area seeded under crops of rabi recorded an annual increase of 7.3% in healthy as of November 26, 2021. This is due to the increase in area under some high elements. inflation such as oilseeds as well as pulses and wheat, partially offset by the decrease in area sown to rice and coarse grains.
However, the prices of vegetables have skyrocketed. Additionally, producers struggling with cost pressures resulting from soaring global commodity prices and logistics costs have announced price increases in a number of sectors, which should keep core inflation down. at a high level.
Overall, we expect CPI inflation to show around 4.7% in November 2021. As the base effect weakens, we expect it to harden. at an uncomfortable level of 5.5-6% in Dec-March FY22, approaching the upper end of the mid-term MPC target range of 2-6%. Overall, CPI inflation is now expected to average 5.5% in FY22, 20 basis points higher than the 5.3% forecast made by the MPC in its review. October 2021.
Signals about the dynamics of economic growth are also mixed. India’s real GDP grew 8.4% year-on-year in the second quarter of FY22, beating the MPC forecast and our own forecast by 7.9%. With this, the absolute level of GDP has returned slightly above the pre-pandemic level of T2FY20, one of the measures monitored by the MPC. However, we argue that general signs of a sustainable recovery were missing in the disaggregated GDP data.
Encouragingly, gross fixed capital formation increased by 1.5% in T2FY22 compared to T2FY20, echoing developments in the production of capital goods and public capital expenditure. However, private and public consumption spending in T2FY22 was 4% and 17% behind, respectively, from its pre-Covid-19 level. The impact of this was offset by an increase in valuables from the pre-Covid-19 level in Q2 FY20, driven by the near-tripling of gold and silver imports.
At constant 2011-2012 prices, valuables at T2FY22 exceeded the T2FY20 level by Rs 0.8 trillion, far more than the slight absolute increase of Rs 0.1 trillion in GDP during this period. This is the main reason we are cautious, despite the T2FY22 GDP exceeding our forecasts.
Additionally, some key sub-sectors such as manufacturing, mining and construction showed lower GVA growth in the second quarter of fiscal 22 compared to the volume expansion reported by IIP, suggesting that rising input costs have undermined corporate margins. Going forward, increased national immunization coverage and reductions in fuel taxes will build confidence and invigorate demand, leading to higher volumes. However, with high input prices, either the margins will be further reduced or higher prices will limit the recovery in consumption in S2FY22.
After a generally healthy holiday season, some indicators showed a slowing momentum in November 2021. For example, the average daily production of TPS electronic invoices decreased considerably to reach 2 million from November 1 to 28, 2021, compared to the record of 2.4 million seen in October 2021. Electricity growth fell in November 2021 to a low 2%. In addition, vehicle registrations have contracted on an annual basis. In contrast, the November PMI rose further, reflecting improved mobility data.
Following the improvement in the visibility of tax revenues, we anticipate a sustained pace of central government and state spending in S2FY22, even if the base effect is particularly unfavorable in Q4FY22. In addition, recent releases of the remaining tranches of the back-to-back GST compensation loan as well as an additional disbursement from central fiscal deconcentration would increase state governments’ cash flows, pushing them to increase spending. This is positive for growth, as government spending is an important part of improving business confidence and economic activity.
Disappointingly, the discovery of the Omicron variant has rekindled uncertainty about the strength of global demand and cross-border flows, as well as the assurance provided by current Covid-19 vaccines, while at the same time triggering some correction of commodity prices.
In light of the renewed uncertainty, we expect a status quo from the MPC and RBI during the December 2021 policy review on position and rates. However, the tone could change to signal an imminent shift in monetary policy stance to neutral during the February 2022 policy review, as long as Omicron does not require further lockdowns in the coming weeks. We expect the change in stance to be accompanied by a 15bp hike in the RBI reverse repo rate in February 2022, reducing the political corridor to 50bp from the current 65bp.
Thereafter, our baseline scenario continues to forecast increases of 25 basis points each in repo and reverse repo rates during the April 2022 and June 2022 reviews, followed by a reassessment of the repo rate. sustainability of the resumption of growth as political support is withdrawn.
The author is Chief Economist, ICRA