RBI leans harder to rein in inflation, but rebound in services will put upward pressure on prices

A rate hike in the monetary policy committee’s June meeting was a foregone conclusion after the spike in inflation and an off-cycle surprise interest rate hike on May 4. The only deliberation was on the quantum of increase. In this context, a 50 basis points hike confirmed that the RBI is leaning harder to control inflation.

A fast-forwarding of interest rate hikes was unavoidable because of five reasons. One, a confluence of factors has pushed higher inflation and made it persistent and broad-based. The RBI also raised its inflation forecast by 100 basis points to 6.7 per cent for the current fiscal. Two, even with this hike, the repo rate, the signaling tool for bank interest rates, is still below pre-pandemic levels. The real policy rate (repo rate less expected inflation) remains negative and has some distance to cover before it reaches positive territory — where the RBI would like to see it. Three, monetary policy impacts growth, and thereafter, inflation with a lag. To control inflation, the RBI needed to act faster by front loading rate hikes. Four, the risk of inflation expectations getting unmoored had risen. Household and business inflation expectations remain elevated, as indicated by the RBI’s inflation expectations survey of households and IIM Ahmedabad’s business inflation expectations survey. Five, the aggressive stance of the US Federal Reserve and ensuing tightening financial conditions. India is better placed today than in 2013 to face the Fed’s actions with a stronger forex shield.

That said, India is not insulated. Also, the headwinds now are stronger than in 2013 and we have seen net capital outflows since October 2021. S&P Global expects the US federal funds rate to be raised to 3-3.25 per cent in 2023, higher than the pre-pandemic level, and highest since early 2008. Despite a strong forex hoard, the RBI has had to deploy monetary policy to mute the impact of the Fed’s actions.

What does all this mean for growth and inflation? We expect inflation to average 6.8 per cent this fiscal. The risks to the forecast are still tilted upwards as all the key components of CPI — food, fuel and core — show no signs of relenting. The pressure on food inflation has increased owing to the impact of the freak heatwave on wheat, tomatoes and mangoes, which is driving prices higher. This is on top of rising input costs for agricultural production, the global surge in food prices and the expected sharper than usual rise in minimum support price. Fuel inflation will remain high, duty cuts notwithstanding, as global crude prices remain volatile at elevated levels.

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Core inflation, the barometer of demand, is a complex story. Despite a relatively weak consumer demand in many pockets, it was printed at 7.1 per cent in April. As for its ingredients, goods (despite only partial pass-through of input costs) are witnessing higher inflation than services. During the pre-pandemic years (2015-16 to 2019-20), services inflation was higher than goods inflation. After the pandemic, services core inflation averaged 4.6 per cent, while the goods part was around 6.2 per cent in the last two years and currently stands at 5.4 per cent. That’s because services faced tighter restrictions during the Covid-19 waves, restricting their consumption and the pricing power of providers as well.

This is changing with the rebound in contact-based services. Overall services inflation is still low as some large essential services with significant weightage are bringing down the headline. Categories that are mostly regulated, such as public transport, railways, water and education, have over 50 per cent weight in core services. However, prices of discretionary services such as airlines, cinema, lodging and other entertainment are rising. Some essential services such as internet, health and mobile charges, too, saw high inflation because of their growing relevance with the fast-forwarding of digitalisation.

Transportation-related services have seen the sharpest rise in the past six months due to fuel price increases. CRISIL’s freight price index shows a growth of around 22 per cent in May this year. With the rebound in services expected to continue, the input prices will be passed on rising to consumers.

Not all aspects of supply-driven inflation can be addressed via monetary policy. So the authorities are complementing monetary policy actions by using the limited fiscal space to cut duties and extend subsidies to the vulnerable. Despite these measures, consumer inflation is unlikely to print below 6 per cent (upper band of the RBI’s target range) before the last quarter of this fiscal year which incidentally is the RBI’s projection as well.
We expect GDP growth at 7.3 per cent this year, with risks tilted to the downside. S&P Global has recently cut the growth outlook for major for 2022 — that of the US to 2.4 per cent from 3.2 per cent, for Eurozone to 2.7 per cent from 3.3 per cent earlier, and for China to 4.2 per cent from 4.9 per cent . This will hurt exports which are very sensitive to global demand. The longer the Russia-Ukraine conflict continues, the longer would be the dislocation of commodity and crude markets.

For those at the bottom of the pyramid, high inflation hits harder because energy and food are a big chunk of their consumption basket. That said, not everything is gloomy because offsetting factors are emerging. A normal monsoon will support agriculture, particularly if well-distributed. As vaccination coverage improves and people learn to live with the virus, growth will get a boost from a strong bounce-back in contact-based services, which, in 2021-22, were 11.3 per cent lower than the 2019-2020 levels.

Monetary tightening impacts growth with a lag of at least 3-4 quarters so the peak impact of rate hikes will be felt towards the last quarter of this fiscal and the first quarter of next.

That, and the fact that real interest rates are negative and borrowing rates still below pre-pandemic levels, implies monetary policy is unlikely to be growth-restrictive for this year.
The writer is chief economist, CRISIL


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