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RBI Monetary Policy: MPC’s Dilemma – Is Output Gap Closing, Embedding Inflation?

The critical question before the MPC will be the extent of the output gap and the speed with which it can close in coming months.

<div class="paragraphs"><p>Workers  at a flyover construction site in Patna, on Feb. 25, 2021. (Photographer: Anindito Mukherjee/Bloomberg)</p></div>
Workers at a flyover construction site in Patna, on Feb. 25, 2021. (Photographer: Anindito Mukherjee/Bloomberg)

While every monetary policy review following periods of extraordinary countercyclical responses presents difficult choices for an exit strategy, the forthcoming one will present a particularly difficult mix of trade-offs. Economic activity had been hit following the two-year-long series of public health responses of varying intensity during the Covid-19 pandemic, including a permanent loss of income. Just when signs of a recovery in February 2022 began to emerge, with a progressive easing of restrictions giving play to pent-up demand, the Ukraine crisis and the resulting sanctions and disruptions of global energy and commodities supply chains have dealt both an output and price shock. India, being a large energy importer, is likely to be significantly impacted.

Even before the geopolitics-related shocks, price pressures had been getting entrenched across developed markets, with almost unprecedented levels of inflation. In the United States, in particular, labour markets remain very tight, with concerns of price, wage, and asset inflation getting embedded in household expectations. The U.S. Federal Reserve is now widely perceived as being ‘behind the curve’ and has signaled a steep tightening cycle, at least for 2022.

Inflation in India too has remained elevated since December 2019 and seems to be becoming more broad-based in recent months. The critical question before the Monetary Policy Committee will be the extent of the output gap and the speed with which it can close in the coming months. RBI has done extensive analytical work on estimating potential output, the Phillips Curve, and other measures of system slack. The RBI Deputy Governor, in comments late last year, had indicated that the output gap at that point might take many years to close. At the same time, the Phillips Curve—the tradeoff between inflation and the output gap—had begun to steepen in recent years, implying that inflation had begun to respond to aggregate demand. In addition, the inflation process has become sensitive to forward-looking expectations.

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Charting The Output Gap

All this points to the need for a hard look at the likely output gap in the present economic conditions and how quickly this might close. This article looks at some heuristic measures as proxies for the gap and slack in the system.

To begin with, the Axis Bank Composite Leading Index of economic activity – constructed from 39 high-frequency activity indicators – shows a fairly marked uptick in March, but this is based on a select set of ‘nowcasting’ metrics, like mobility and electricity consumption, whose correlation with underlying demand appears to have progressively weakened over the pandemic months. On the other hand, indicators like Manufacturing PMI and GST collections suggest that activity levels are not weak.

Measuring Capacity Utilisation

The first and obvious indicator of the output gap—in manufacturing—is capacity utilisation levels. The most definitive measure is from RBI surveys, and the last reading of September 2021 showed capacity utilisation improve to 68% from 60% in June 2021. The first chart shows the co-movement of utilisation with the Index of Industrial Production.

This, in conjunction with anecdotal evidence from select sectors, suggests that the utilisation level is probably significantly above 70%, and close to the 75% levels around which capacity begins to materially tighten.
RBI Monetary Policy: MPC’s Dilemma – Is Output Gap Closing, Embedding Inflation?
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Comparing Margin Performance

Another relevant proxy of the output gap is the operating profit margins of companies. This metric is broader in scope and captures likely demand conditions in both manufacturing and consumption, basis the ability of manufacturers to pass on higher input costs to end-consumer product prices.

We have used the quarterly financial results of a set of listed companies to aggregate corporations into two groups:

  1. A set of largely business-to-business wholesale-oriented or supply to intermediates suppliers; and

  2. Business-to-consumer retail-oriented companies that are more end-consumer facing.

The next chart shows trends in OPMs of these two groups.

In aggregate, it can be seen that after a period of relatively close tracking prior to the pandemic, a large gap opened up in the post-first Covid wave quarters. Continuing demand weakness is also evident during the second wave.

Thereafter, a likely combination of falling input inflation and moderating demand leads to the OPMs of the two groups converging towards each other in Q3FY22. We think that in Q4, the OPMs of both groups will have trended up.

RBI Monetary Policy: MPC’s Dilemma – Is Output Gap Closing, Embedding Inflation?

These trends, though, are not uniform across sectors.

In the automobile sector, for instance, OPMs had risen for metals suppliers to automobile original equipment manufacturers (B2B supply), and have remained much more subdued for the more (B2C oriented) vehicle makers, ancillary and tyre manufacturers. So also is the case for the consumer durables sector, where the OPMs of intermediates and consumer durables makers have remained much weaker than that of the input suppliers (metals). Paints and plastics companies, however, seem to have been able to pass on higher chemicals input costs. OPMs of textiles companies have moved very closely with chemicals.

Most interesting, FMCG companies have managed to retain OPMs higher than those of companies supplying them with some of their inputs.

On the whole, this seems to suggest that demand in at least some pockets of consumer goods has remained relatively strong.
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Policy Tightening Needed Sooner Than Later

So what does all this imply for monetary policy actions at this point? We expect that MPC will choose to hold the policy parameters, given the magnitude and pervasive scale of uncertainty for global and domestic economic conditions in the immediate future. However, persisting inflation is increasingly becoming a concern. We expect CPI headline inflation to print at 6.3%+ for March, and average 6.1% in Q1FY23, 6.2% in Q2, and 5.9% for the full year FY23, all with upside risks.

Despite the expected muted path of growth recovery in FY23, concerns on price stability and unanchored inflation expectations will need a monetary policy tightening response at some point, probably earlier than delayed, particularly given the still fairly loose fiscal conditions. RBI has emphasised that any tightening actions will be telegraphed well in advance. Hence, in addition to a significant upward revision in the February meet FY23 CPI inflation forecast of 4.5%, it will be interesting to see the emergence of any significant changes in the syntax of the MPC statement.

Saugata Bhattacharya is Executive Vice President and Chief Economist at Axis Bank. Views are personal.

The views expressed here are those of the author, and do not necessarily represent the views of BloombergQuint or its editorial team.