Inflation stays elevated: When will the RBI act?

RBI's policy dilemma has come when many emerging markets central banks hiked interest rates in June to fight inflation while indicating more hikes

Consumer price-index based inflation stayed above the central bank's comfort zone for the second consecutive month in June, which rose by 6.26 per cent after rising 6.3 per cent in May. Consumer Inflation remained elevated due to rising prices of fuel and food. While the number was lower than the consensus estimate of 6.6 per cent, food prices pressure remains elevated, and energy prices continue to increase.

Food inflation in June accelerated to 5.15 per cent from 5.01 per cent in May. Inflation in the 'fuel and light' category stayed high at 12.68 per cent during the month as against 11.58 per cent in the previous month. "India's inflation is being driven by non-domestic factors, limiting policy options and squeezing profit margins," says Rahul Bajoria, chief India economist, Barclays.

"As demand improves following India's second wave of Covid19 infections, we believe firms will increase prices to sustain higher volumes. As a result, even if imported price pressures recede, margin normalisation may keep CPI inflation elevated and sticky," Bajoria says.

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The RBI Act mandates the monetary policy committee of the central bank to keep inflation at 4 per cent, within a range of +/-2 per cent. Average inflation in the previous financial year was 6.22 per cent, and for the current year, it is projected at 5.1 per cent by the central bank during the last monetary policy review in June.

It has been a tough balancing act for the central bank as growth continues to be fragile while inflation staying elevated. After the pandemic broke out last year in March and a nationwide lockdown was imposed, the RBI promptly reacted by cutting the key policy rate, which is the repo rate, by 75 bps in March and another 40 bps in May. Since then, the policy rate stayed at 4 per cent, and the RBI continued to maintain an accommodative stance by keeping ample liquidity in the banking system. The pandemic has taken a toll on the economy. The GDP growth contracted 7.3 per cent in the previous financial year – its worst performance since independence.

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While many projected double-digit GDP growth in the current financial year, such projections were revised downwards following the second wave. In its June monetary policy review meeting, the central bank revised its growth projection for 2021-22 to 9.5 per cent from 10.5 per cent, which it had projected during the April meeting. Rating agencies and brokerages also revised their GDP growth projections following the second wave.

So far, there has been no indication from the central bank on when it plans to exit the ultra-loose monetary policy. The RBI had said it would maintain the accommodative stance "as long as necessary to revive and sustain growth on a durable basis and continue to mitigate the impact of Covid-19 on the economy."

Economists see average retail inflation for the current financial year to stay close to the upper bound of the central bank's target. Most economists projected higher average inflation than the central bank's projection of 5.1 per cent.

While concerns about growth are real, the average return to the savers has been negative for close to two years since inflation is higher than what most banks offer on fixed deposits, around 5 per cent for deposits maturing between one year to three years.

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However, it is unlikely that the central bank will start exiting from the accommodative stance any time soon. Such unwinding of the ultra-loose policy could only happen in 2022, economists said. "We continue to expect retail inflation at 5.5 per cent in FY22, led by higher core inflation at 6.1 per cent. Monsoon is now below normal and poses an upward risk to our inflation estimate," economists at Bank of Baroda said in a note to its clients. "We expect RBI to normalise monetary policy in Q4FY22 by reducing the wedge between reverse repo and repo rate and changing its liquidity stance," the report said.

The Indian central bank's policy dilemma has come when many emerging markets central banks hiked interest rates in June to fight inflation while indicating more hikes in the coming months. Some of the emerging market central banks that increased interest rates are Brazil, Russia and Mexico.

"After having risen sharply in May, June inflation has stabilised near the same levels, printing 6.26 per cent versus our expectations of 6.61 per cent. While the low base continued to impact the YoY headline print, the sequential increase has been much more muted than the sharp surge seen in May," says Madhavi Arora, Lead Economist, Emkay Global Financial Services.

"The MPC (Monetary Policy Committee) may still choose to look through the spike in inflation in the near term, with the monetary reaction function currently hinging more on growth revival becoming sustainable. We still do not see any change in policy rates this year," she says.

The six-member Monetary Policy Committee (MPC) of the RBI – which sets the interest rate – will meet on August 4-6 to review the policy. It is to be seen if the persistent inflation pressure will force the members to start contemplating exiting the accommodative stance sooner than later.