May inflation shocker may advance RBI's policy normalisation act

MPC likely to revise inflation forecast upward in August policy review

With May inflation prints giving a rude shock, Reserve Bank of India governor Shaktikanta Das may now have to review his stance on normalisation of the ultra-loose monetary policy. Das had assured the market earlier this month that normalisation of the policy, which has been enforced since the pandemic broke out in March last year, is not on the cards anytime soon.

The consumer price index-based inflation – the main yardstick of RBI for policy making purpose - rose in May, to 6.3% against the market estimate of 5.4%, with an across-the-board rise in food, fuel and core inflation. While May was the month of peak lockdown in the second Covid wave, which has contributed significantly to the spurt, there are doubts if price jump will reverse once the lockdowns are lifted. To make matters worse, the wholesale price index-based inflation accelerated to a multi-decade high of 12.94% in May.

“Our judgement is that prices are downward rigid in India, and as such, only part of the price rise will reverse when lockdowns are fully relaxed in coming months,” analysts at Nomura said. Nomura has revised its projection for average CPI inflation to 5.6% for 2021 as compared to 5% earlier, while core CPI is seen at 6.2% as compared to 5% earlier.

“The upside surprise in May CPI will throw a spanner in the MPC’s growth priority stance,” Nomura said, adding the May rise in inflation cannot be overlooked by RBI on the ground that it is statistical unlike April of last year. Observing that the central bank does not have sufficient information to judge the rise in prices in transient, the brokerage said due to inflationary pressures, policy normalisation may begin in the fourth quarter with a reverse repo hike to 25 bps and a total of 75 bps repo rate hike in 2022. (100 bps = 1 percentage point)

The six-member monetary policy committee (MPC) of RBI, which sets interest rate, reduced the policy repo rate by 115 bps since the pandemic broke out in March last year. The committee has also maintained an accommodative stance and said such a stance would continue "as long as necessary to revive and sustain growth on a durable basis" and ruled out any talks of normalisation of its approach.

“With regard to normalising the policy stance, there is no thinking at the moment… it is too early, it's too premature to talk about that,” Das said during the post policy interaction with the press on June 4. The central bank has been accommodative on interest rates and liquidity throughout the pandemic even if inflation was on a higher side. Average inflation in the previous financial year was 6.22%.

“With core inflation spiking too, RBI’s tolerance could be tested,” Edelweiss Securities said in a note.

“While current inflation print has little to do with demand or RBI’s ample liquidity (as credit growth is yet to pick up), it could potentially turn MPC a bit cautious. We do not anticipate any rate action, but RBI may look to advance its liquidity normalisation or let INR appreciate to fight inflation,” Edelweiss said.

The May inflation spike has prompted most analysts to revise the inflation projection for the current financial year. The central bank, which revised its inflation projection to 5.1% in June from 5% in April, may further revise it upward during the next policy review meeting scheduled 4-6 August.

“We raise FY22 inflation forecast to 5.45% from 4.7%. Even assuming food inflation averaging around reasonable levels, core inflation should average above 6%, outdoing headline inflation,” Emkay Global said on the back of "unexpected surge" of CPI inflation.

The bond market reacted on the higher inflation print with the yield on the 10-year benchmark government bond jumping 4 bps on Tuesday to end the day at 6.04% - indicating the traders’ apprehension that the process of normalisation may be advanced than what was expected earlier.

Normalisation talks by the central bank, in January this year with the resumption of variable rate reverse repo auctions, had made the bond markets nervous. Weeks later when the Union budget announced additional borrowing, apart from Rs 12 trillion borrowing for the current financial year, yields started rising. Since then, the central bank has been trying to manage undue volatility on the yields – primarily on the 10-year paper – with opening of liquidity taps and even assuring on periodic bond buying under the Government Securities Acquisition Program (G-SAP) programme.

“The May CPI print will likely push up the importance of inflation in the growth versus inflation tradeoff for RBI,” said Suyash Choudhary, Head – Fixed Income, IDFC AMC.

“This doesn’t necessarily mean that the central bank will start to respond to this right away. However, the bond market may step up speculation with respect to the shelf-life for RBI’s current ultra-dovishness. This may make the task of dictating yields to the market that much more difficult for the central bank,” he said.

some of the bond market participants have remarked that the central bank has been aggressively dovish, as reflected in aggressive bond market intervention, with an effort to dictate the 10-year bond yield. However, it is to be seen what else is there in the central bank’s arsenal to sound incrementally dovish, which would keep yields under check amid rising prices.