50% chance of RBI erring on inflation; likely post-poll fuel price revision key CPI risk: Nomura

NEW DELHI: At its monetary policy meeting earlier this month, the Reserve Bank of India made it clear that its priority lay in reviving economic growth sustainably, especially as the central bank expects elevated consumer prices to cool off in the second half of the next financial year.

The RBI’s push to ensure the durability of the growth recovery is undoubtedly justified given the extent to which the COVID-19 crisis has scarred India’s economy but Nomura believes that the central bank has it wrong when it comes to assessment on inflation.

The foreign firm is of the view that a combination of upward price pressures including a delayed realignment of fuel prices, hardening agricultural input costs, elevated commodity prices, pressures from reopening of services and higher inflation expectations could all result in inflation outturns outstripping the RBI’s estimates.

“The pump prices of petrol/diesel/LPG have been frozen since November 2021 due to the state election, and need to be revised up by nearly 10 per cent for petrol/diesel and over 30 per cent for LPG to bring them on par with international prices. We expect a gradual upward adjustment to begin in March, although LPG prices are likely to be revised by less than the current gap. A 10 per cent rise in crude oil prices typically leads to a 0.3-0.4 pp (percentage point) rise in headline inflation,” Nomura’s analysts wrote.

“Food prices in India do not always move in sync with global food prices, but rising farming costs (fertiliser/pesticide, diesel and farm equipment) are a source of upward pressure. Rising global food prices will also likely indirectly influence the minimum support price settings this year. Any potential downside from lower edible oil, pulses and sugar price inflation could be offset by higher wheat and spices inflation.”

With international crude oil prices skyrocketing following Russia’s invasion of Ukraine, the upward pressure on domestic fuel prices has significantly increased, given India’s huge import dependence on the commodity. Brent crude oil prices have added more than 30 per cent so far in the current calendar year, with the most active contract currently trading around $103 per barrel.

While acknowledging the risks emanating from high crude oil prices at its policy statement on Feb 10 – the Brent crude contract was around $90 per barrel at the time – the RBI said that it expects supply conditions for crude oil to turn more favourable during 2022 while pointing out that a softening in the pace of rise in selling prices by the manufacturing and services firms reflected a subdued pass-through.

The central bank, which maintained a status quo on all key interest rates and retained its accommodative stance at the meeting, predicts Consumer Price Index-based inflation at 5.7 per cent in the ongoing quarter and 5.3 per cent for the current financial year as a whole. For the coming fiscal, headline retail inflation is pegged at 4.5 per cent.

CPI inflation, which the RBI is mandated to keep with a 2-6 per cent band, was at 6.01 per cent in January. The central bank’s medium-term target for the price gauge is 4 per cent.

Even if the RBI’s inflation view turns out to be accurate – a scenario to which Nomura ascribes a 15 per cent probability – the need to find a solution to the negative real interest rate prevalent during the pandemic suggests 50 to 75 basis points worth of rate hikes in the next financial year, the foreign firm said.

Nomura’s base case scenario, which assigns a 50 per cent probability to the RBI erring on inflation, is that upside inflation surprises starting April would lead to a hawkish pivot from the central bank.

“Our MTR (Modified Taylor Rule) estimates suggest policy rates will need to rise from 4.00 per cent currently to 5.75-6.00 per cent by March 2023 (not our forecast) to catch-up with the ‘should be’ curve on policy rates.

Nomura’s third scenario is one where the RBI’s inflation turns out to be incorrect but the central bank continues to tolerate elevated inflation, primarily to support the economic recovery and the centre’s massive borrowing programme.

With the government announcing a mammoth Rs 14.95 lakh crore worth of gross bond sales in the next financial year, a tighter monetary policy could risk the smooth passage of the government’s borrowing programme – the success of which is crucial to the centre’s aim of spending more to revive growth.

“This is a scenario of fiscal dominance, in which policy rates rise by much less than we expect in 2022, but macro risks – both inflation and external – could be much higher than our current baseline, prompting more catch-up in 2023. We see a potential stagflationary outcome in this scenario.”



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