RBI’s Monetary Policy Imperatives And The Omicron Curve-Ball
The discovery of ‘Omicron’, the new mutation of the coronavirus in South Africa, and some evidence of its transmission to Europe and North Asia might just put the “best-laid plans of mice and men” well and truly “gang aft agley” (go awry) to quote the Scottish poet Robert Burns. The recent rout in markets across asset classes and geographies might well be the beginning of another phase of growth fears among policymakers and investors. The assumption that the Covid-19 pandemic had morphed into a tame endemic, and the only thing to fret over was inflation, suddenly does not look so best-laid after all.
It is up to epidemiologists and medical professionals to gauge the tenacity of the virus. That, in turn, would determine the severity of containment measures and the dent to economies. As economists, we can think of two distinct possibilities. The first is that there is evidence that comes our way soon enough that the virus can be easily contained, existing vaccines provide an adequate shield, and hospitalisations and fatalities are unlikely to spiral. Then the news of this virus would largely work as a trigger for corrections in financial markets that was long overdue. Thus Omicron could act essentially as a long-awaited wake-up call.
However, historically these correction triggers lead to knee-jerk reactions followed by a pull-back. Thus, the first possibility or the ‘trigger scenario’ is one in which markets settle at saner levels post-correction and the damage to underlying economies remains limited. Thus, the fundamental drivers of policy direction, particularly monetary policy, remain unchanged. At this stage, we are putting our money on this scenario.
The second scenario is one in which the new variant leads to a major infection surge across the world, is relatively resilient to vaccines, and requires new treatment modalities. This would drastically alter growth projections as well as create new supply shortages. Monetary and fiscal policy would have to respond to this and focus would again have to shift, at least to some degree, towards offsetting the damage to growth and incomes. This is easier said than done since unlike earlier waves of Covid-19 when all policy engines were stoked for growth, this involves a complete U-turn from the current policy alignment that has been busy setting up a defence against inflation.
RBI’s Liquidity Normalisation Already Underway
Coming to the Reserve Bank of India’s monetary policy and the announcement that is due on Dec. 8, we wonder if conventional descriptions such as ‘accommodative’ or ‘neutral’ remain as relevant in exceptional situations such as a shift from crisis-fighting to more normal circumstances. For one thing, these terms pertain largely to the official policy rate – the repo rate in India’s case. However, following the 2008 financial crisis playbook, monetary crisis management has worked largely through managing the quantum of liquidity – the price of liquidity.
Over the last two months, variable-rate reverse repo cut-off yields have moved up by 40-60 basis points, making their way from being close to the reverse repo of 3.35% — so far the de-facto overnight operating rate — to the repo rate. The system liquidity balances under the overnight window have almost halved, reducing from Rs 4.1 lakh crore before the October policy to Rs 2 lakh crore as of Nov. 28. Moreover, the RBI has been selling bonds in the secondary market in November (close to Rs 1,435 crore), absorbing liquidity from the system.
Thus to attribute a degree of callousness towards inflation simply because the RBI chooses to remain ‘accommodative’ is perhaps misleading. One has to look at the liquidity balances and the yield curve to judge the RBI’s stance. The central bank is likely to follow this tack in trying to put a lid on inflation without altering its stance.
Anticipating Specific Policies
A reduction of the policy corridor by way of an increase in the reverse repo could be next or even a permanent liquidity absorption facility like a Standing Deposit Facility could be used. If secondary market sales are not sufficient there is the off-chance that Market Stabilisation Scheme bonds are brought back in a bid to normalise liquidity further. That said, it is but natural for a central bank to be ultra-cautious.
The cloud of uncertainty around the new Covid variant might induce the RBI to hold off on its plan for another two months and go slow on liquidity normalisation for a while. Thus a hike in the reverse repo rate might be put on hold.
RBI’s monetary normalisation might seem to be more subtle than the likes of the U.S. Federal Reserve that is actively tapering its bond purchase programme, but then the relatively small size of the fiscal stimulus in India (about 3.5% of GDP compared to America’s 26.5%) means that the RBI has to err on the side of growth.
Inflation Path Going Forward
At face value, India inflation readings look comfortable, especially compared to the rest of the world but they are artificially being pulled down by a high base from last year. As this comfort fades, we expect inflationary pressures to reveal themselves and the readings to chart their back up to 6% by January-March 2022. This is confirmed by elevated core inflation (excluding food and fuel) that has become more persistent since the onset of the pandemic.
Our core inflation diffusion index (which captures the synchronisation of monthly increases in core sub-categories) jumped above 100 in October. A value above 50 signals a more broad-based increase in inflation. As the economy recovers further and the output gap narrows, core inflationary pressures, if not roped in, could become entrenched in inflation expectations and kick start a rather notorious wage-inflation spiral.
The other issue is on the supply side. Contrary to previous expectations that supply disruptions will resolve themselves in the near term and the impact on inflation would be transitory, supply chain issues are now expected to linger on for another 6-8 months keeping inflation under pressure. For instance, industry experts expect the semiconductor chips shortage that has impacted production from the likes of phones to cars to persist at least till the second half of 2022. On average, the global lead time on semiconductor chips (difference between ordering and delivery) has doubled to almost 22 weeks over the last few months. To add to this mix, if the new Covid variant were to lead to further pressure on already fractured supply chains, inflation readings could rise further.
We find that a 10% decline in India’s industrial production leads to a 40-basis point increase in retail inflation.
At a time when demand is picking up globally, supply is struggling to catch up, asset prices are inflated with liquidity levels still in surplus, central banks across the world including the RBI will find it increasingly difficult to turn away from inflation. Although time will tell whether the Omicron Covid variant risk derails these plans or puts a brief pause on them. The bottom line is that it’s time that the genie of inflation needs to be pushed back into the bottle.
Abheek Barua is Chief Economist, and Sakshi Gupta is Senior Economist, at HDFC Bank.
The views expressed here are those of the authors and do not necessarily represent the views of BloombergQuint or its editorial team.