MPC to maintain accommodative stance at least in the next two reviews

In February 2021, the Government of India (GoI) had unveiled the Union Budget for fiscal 2021-2 (FY22), which targeted a growth-boosting expansion in capital spending for the upcoming fiscal. The latest available consumer price inflation (CPI) prints had shown a sharp correction to 4.6 per cent in December 2020. Moreover, we were sanguine that the worst of the Covid-19 pandemic was firmly behind us.

This was the backdrop at the time of the Monetary Policy Committee’s (MPC’s) final scheduled review for FY21, which was the last meeting before the review of the inflation-targeting framework by the GoI.
 

At that meeting, the MPC had kept the repo rate unchanged at 4 per cent, in line with its primary mandate of ensuring that the CPI inflation remains within a band of 2-6 per cent; this target has now been retained by the GoI until March 2026.

In the February 2021 review, the MPC had placed its CPI inflation projections at 5.2 per cent in Q4 FY2021, 5.0-5.2 per cent in H1FY22 and 4.3 per cent in Q3FY22, with risks broadly balanced.

After declining to 4.1 per cent in January 2021, the CPI inflation reared up to 5 per cent in February 2021, and we expect it to exceed 5.5 per cent in March 2021. Even as fuel prices remain high, a revival in commodity prices, demand and pricing power are likely to result in the core inflation being relatively sticky in FY22. Accordingly, we anticipate that the average CPI inflation in FY22 will remain well above 4 per cent, the mid-point of the MPC’s medium-term inflation target band. Therefore, our baseline expectation is an extended pause for the repo rate through 2021.

On the growth front, the MPC had expected the urban demand and demand from contact-intensive services to strengthen with the decline in the Covid-19 cases and the vaccine rollout, whereas rural demand would remain robust with the favourable agricultural outlook. It had highlighted that the thrust toward health, infrastructure, innovation, etc. provided in the Union Budget 2021-22 should aid in accelerating growth momentum. It projected the real GDP expansion at 10.5 per cent in FY22.

Our forecasts peg the expansion in Indian GDP and the Gross Value Added (GVA; at constant 2011-12 prices) in FY22 in a range of 10-11 per cent, benefitting from a normalisation in economic activity after the vaccine rollout widens, as well as the low base. The key upside to these projections is a faster-than-expected pickup in Government spending. The key risks are a sustenance of the latest wave of Covid-19 infections and its spread to additional states, the existing vaccines not being effective enough against new variants of the infection, and a spike in commodity prices to a level that starts to constrain demand.

The disconcertingly sharp new wave of Covid-19 cases has reignited uncertainty regarding the economic outlook in the immediate term. Accordingly, we expect the MPC to maintain the accommodative stance over at least the next two policy reviews, possibly until the vaccines become available in India for all adults.

While the repo rate is expected to be kept unchanged, and liquidity remains ample, bond yields are likely to remain on edge given prevailing inflationary pressures, firming of global interest rates, and large Central and State Government borrowings.

Although modestly lower than the year-ago level, the dated market borrowing programme of Rs. 7.24 trillion unveiled by the GoI for H1 FY2021, is substantial. However, the healthy GST collections in the month of March 2021, along with the additional devolution of Rs. 450 billion to the state governments for the just-concluded fiscal, confirm our view that the GoI’s tax revenues in FY2021 have exceeded its Revised Estimate (RE). As a result, we expect the GoI's fiscal deficit to undershoot the FY2021 RE of Rs. 18.5 trillion, suggesting ample cash balances at the start of FY22. The magnitude of this cash surplus, along with size and frequency of the upcoming open market operations to be conducted by the Reserve Bank of India, will guide where yields settle over the next few months.

Aditi Nayar is Principal Economist at ICRA. Views are her own.