RBI no longer behind the curve in tackling inflation risk from geopolitical tensions

The SDF has replaced the fixed rate reverse repo (FRRR) as the floor of the LAF corridor. By introducing SDF, the RBI has restored LAF corridor (width 50 bps) with SDF at the base of 3.75% and MSF at 4.25%. While the RBI kept its monetary policy stance unchanged, it changed its wording to “remain accommodative while focusing on withdrawal of accommodation”.

This signals that the central bank is perhaps gearing up to change its stance to neutral in the upcoming policy meet/s.

Clearly, the priorities have changed, inflation risks emanating from global factors took the centre stage from earlier pro-growth supportive policy. Russia’s invasion of Ukraine has fuelled an upward march of commodity prices all over the world. Global food prices, commodity and metal prices have also hardened significantly.

Inflation concerns have aggravated as oil prices rose, pass through to retail prices began and secondary impact will be witnessed in the coming months. RBI now believes that inflation risks are no longer transitory and that the supply side shock and its input cost related pressures are expected to linger even longer.

On the back of these conclusions, RBI increased inflation forecasts from 4.5% to 5.7% for FY23, on the assumption of a normal monsoon in 2022 and average crude oil price (Indian basket) of US $ 100 per barrel. The inflation forecasts were ahead of economists’ consensus of 50-80bps increase.

Food inflation is expected to be pressured over the coming months due to elevated prices of edible oils in the international markets coupled with India’s high import dependency for meeting its domestic demand. With geopolitical tensions showing no signs of respite, the pass-through of rising global oil prices to the transport sector could indirectly affect prices of other commodities. Going ahead, the pass-through of higher input prices is expected to further weigh on the generalised nature of the inflation trajectory.

RBI noted that economic recovery is healthy as recorded from several high frequency indicators – railway freight, GST collections, toll collections, electricity demand, fuel consumption, and imports of capital goods which posted robust year-on-year expansion during February-March.

Business confidence is in optimistic territory and supportive of revival in economic activity. Investment activity may gain traction with improving business confidence, pick up in bank credit, continuing support from government capex and congenial financial conditions.

India is making steady progress on the domestic front nevertheless global developments pose downside risks in terms of spill overs. Being a large importer of oil; rising commodity prices is a negative trade shock leading to more pressure on growth. Real GDP growth for FY23 was slashed aggressively from 7.8% to 7.2%, on the backdrop of global shocks.

Overall system liquidity remains in large surplus though it has moderated. The current average liquidity surplus in the system stands at Rs 8.5 lakh crores. Access to SDF and MSF will be at the discretion of banks, unlike repo/reverse repo, OMO and CRR which are available at the discretion of the Reserve Bank.

Introduction of SDF at 3.75%, will certainly pull up the overnight interest rates. The RBI is trying to flatten the yield curve by pushing the short-term rates higher and would take adequate measures to ensure that yields of long dated securities remain in check.

RBI has moved to the path of gradual increase of policy interest rate and phased withdrawal of liquidity. Days of easy money seems to be behind us, both deposit and lending rates will move up gradually. Also banks were provided a cushion on the HTM front, amid rising interest rate environment.

10 yr Gsec yield breached the 7% mark (first time since June 2019) and moved up 15bps to 7.06%; reacting to the mildly hawkish policy, revision of inflation of GDP forecasts and end of easy monetary policy. Although HTM limit has been enhanced from 22% to 23% till March 31, 2023; bond prices took a hit due to faster than expected policy normalisation from Governor’s speech.

The RBI might intervene through OMOs and operation twists to cap the upside to some extent. Given that that RBI has started draining liquidity from the banking system, it’s unlikely to announce direct bond purchases. Faster global policy normalization amid persistently high inflation, elevated energy prices and huge local borrowing programme are likely to keep long term end of the yield curve at the elevated levels.

Indian bonds if included in the global bond indices in H2FY23 would provide some respite to bond market participants (though taxation issues need to be sorted out at the earliest to smoothen the process). We expect the 10-year Gsec to trade between 6.9-7.3% in H1FY23.

The announcement made it clear that RBI is no longer behind the curve in tackling the inflation risk emanating from global geo-political tensions. It has clearly laid out the path to policy unwinding. The focus from now on will be to withdraw the accommodative policy stance while keeping inflation in check.

We expect the stance to be changed to “neutral” from “accommodative” in the June policy and expect 50 bps repo rate hike in FY23, but the timing will remain a function of evolving growth-inflation risks.

(The author is Head of Retail Research, HDFC Securities)