Festive season trends, Q2 GDP growth will set the stage for policy stance

Given the conflicting signals on the inflation outlook amid a gradually strengthening economic recovery, the October 2021 review of the Monetary Policy Committee (MPC), as well as the accompanying announcements of the Reserve Bank of India (RBI) were on expected lines. 

The MPC unanimously maintained a status quo on the repo rate, and kept the monetary policy stance accommodative with a vote of 5:1, in line with the split seen in the August 2021 meeting. As expected, the RBI refrained from hiking the reverse repo rate without having adequately prepared the markets for the same. However, it took a further step in the direction of liquidity normalisation with a pause in the Government-securities acquisition programme (G-sap) and announced a calendar for 14-day variable rate reverse repo (VRRR) auctions. 

With a softer outlook for food prices being partly offset by the rearing up of prices of edible oils, fuels and metals, input shortages and high logistics costs, the MPC pared its inflation forecast for FY2022 to 5.3 per cent with risks broadly balanced, from the 5.7 per cent projected in the August 2021 review. 

Our own forecasts suggest that the CPI inflation will average 5.3-5.5 per cent in FY2022, only 20 bps lower than our earlier projection. We remain cautious that reviving demand could embolden pricing power, allowing a faster transmission of the supply-side pressures to core inflation.

We expect the MPC to maintain the repo rate and accommodative stance unchanged until demand side factors become the clear driver of inflationary pressures and start to harden inflationary expectations, in order to continue to nurture the demand recovery. The Committee is likely to prefer to look through the surge in fuel costs, while continuing to nudge the Government to relook at fuel taxes.

Despite the Q1 FY2022 GDP growth falling short of the MPC’s projection, it maintained its expectation of a 9.5 per cent GDP expansion in FY2022, led by an upward revision in the forecasts for Q2 FY2022 (to +7.9 per cent from +7.3 per cent) and Q3 FY2022 (to +6.8 per cent from +6.3 per cent). Even with a 7.9 per cent GDP growth in Q2 FY2022, output will remain a shade lower than the pre-Covid level, dampened by the lagging contact-intensive sectors.

  

The festive season trends and upcoming GDP growth print for Q2 FY2022 will guide whether the MPC sets the stage in the December 2021 policy for a change in the policy stance to neutral in the February 2022 policy review, or indicates a further postponement. 

Soaring energy costs, higher VRRR cut offs and market trepidation of an imminent reverse repo hike along with the October 2021 policy review had driven up the 10-year G-sec yield to 6.27 per cent yesterday, despite the benign GoI borrowing calendar for H2 FY2022. With a status quo on rates amidst a pause in the G-sap programme, the 10-year yield has crossed 6.3 per cent intra-day. We now expect it to range between 6.25-6.4 per cent in the remainder of this quarter, unless there is a substantial magnitude of OMO purchase that gets announced for this bucket, and crude oil prices recede under $70 per barrel.

Aditi Nayar is the chief economist at ICRA. The views expressed here are her own.