Race against inflation: Will RBI take a pit stop anytime soon?

After a delayed start, the Reserve Bank of India (RBI) is picking pace in its race against inflation. In the recently concluded Monetary Policy Committee (MPC) meeting on June 8, the RBI decided to hike the policy repo rate by 0.5 per cent (50 bps) to 4.9 per cent. All members of the RBI’s MPC unanimously voted to increase the policy rate and remain focused on the withdrawal of accommodation to ensure that inflation remains within the target going forward while supporting growth.

The RBI so far has increased the policy rate by 90 bps and the expectation is of another 75-100 bps hike in rates in this cycle. This brings to a question – Why could rate hikes be front-loaded in this cycle?

In May consumer prices were 7.04 per cent higher than a year earlier with fuel inflation at 9.54 per cent. Even excluding food and energy prices, annual core CPI inflation is high at 5.90 per cent in May. Surging food and petrol prices are eating into people’s spending power. CPI inflation is expected to remain around 7 per cent for the next few months before moving close to the RBI’s upper tolerance band of 6 per cent on the assumption of a normal monsoon and an average crude price (Indian basket) of USD 105 per barrel. RBI expects inflation to be around 6.7 per cent for FY 2023 vs 5.7 per cent projected in April.

Global crude oil prices continue to remain high. With Europe imposing a further ban on Russian supplies, crude oil prices may continue to remain elevated in the near term. A surge in other global commodity prices has also impacted domestic food prices with food inflation for May coming in at 7.8 per cent. Wholesale inflation runs high at 15.1 per cent, reflecting supply chain concerns and a broad-based increase in input costs for manufacturers and service providers.

Continuing FPI outflows and higher imported inflation are also impacting the Indian rupee. Lately, RBI’s intervention in the forex market is providing some support to the rupee but it’s coming at the cost of reduced forex reserves. Corporates have started to see an impact on margins due to high raw material prices. A larger pass-through would be a challenge as it may hurt demand.

A large part of the rise in inflation is primarily attributed to global supply shocks linked to the war, resilient demand in developed economies, and in recent times to higher food prices. Host of factors such as elevated crude oil and other commodity prices, and resultant pass-through of high input costs, and below-average monsoon pose upside risks to inflation.

This leads to a second question – Will RBI take a pit stop (pause rate hikes) anytime soon?

Global crude oil prices could potentially see some moderation (not immediately) due to the slowdown in China and if the US sees another cycle of recession as crude oil demand will be largely impacted with major economies slowing. Also, the cut in excise duties on petrol and diesel by the government will give some relief to the end-users. It will also moderate the impact of the second-round effect.

The job market in India isn’t heating up (barring sectors such as ITES), unlike what’s happening in the US. If major global economies go through a slowdown/recession, India could also experience a spillover effect with a slowdown in growth as it can curb demand for exports. High-frequency indicators are seeing month-on-month improvement with urban consumption demand and a gradual increase in rural consumption demand – now slightly above pre-pandemic levels. Households are seeing improved affordability and better visibility on income growth which is an encouraging sign for higher credit offtake.

The private consumption demand is just about sub 2 per cent more than the pre-pandemic levels. Inflation is fuelled by high raw material and fuel prices and not by strong consumption demand, yet. Also, increased interest burden (EMIs) with rising interest rates would impact discretionary spending.

In the near term, the ongoing global geopolitical tension could impact global recovery and have a spillover impact on India. Global supply disruptions and a surge in various commodity prices could dampen consumption demand in the near term. This clubbed with a reversal in monetary policy – moving to rate hikes and other tightening measures by major central banks pose downside risks to growth. The MPC would strive to strike a balance on growth-inflation rapidly evolving dynamics and may consider pausing once inflation expectations are anchored.

Is there an opportunity for the debt investor?

The recent surge in yields may create some pain for investors who have entered the debt market in the last six to twelve months. The expectation of another 25-40 bps in the August policy meeting seems to be largely priced in the current yield levels. The term spread (10-year Government security yield minus 3-month T-bill yield) is now ~2.5 per cent vs 3 per cent around the start of the year, although higher than the long-term average of ~1.5 per cent – still retaining its relative attractiveness. Short-term rates for PSU and corporate bonds have also moved up by ~2 per cent since the start of the year, although real rates remain low or negative. Overall, the annual return expectation from bonds would be more normalized as compared to double-digit returns (absolute) delivered during the pandemic.

(The author is Associate Director, Capital Markets & Asset Allocation, Morningstar Investment Adviser India)

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