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High inflation rules out rate easing

Date: 02-12-2020
Subject: High inflation rules out rate easing
We expect the CPI inflation to recede below the upper-end of the MPC’s target range of 6%, only in December, and average a substantial 5.3% in Q4 FY21.

Recent weeks have witnessed simultaneous euphoria regarding the early availability of several Covid-19 vaccine contenders, even as infections have risen in India and many other countries.

The former has pushed up asset and commodity prices, further raising the spectre of elevated inflation for India, while the latter has clouded an assessment of the strength of the economic recovery that may be feasible in the near term. In this hazy context, the Monetary Policy Committee is scheduled to meet on December 2-4, to mull over the policy options and choose a path that is most appropriate for the Indian economy.

In its last meeting in October, the reconstituted MPC had voted unanimously to leave the repo rate unchanged at 4%, and continue with the accommodative stance for as long as necessary to durably revive growth and mitigate the impact of Covid-19 on the Indian economy, whilst ensuring that inflation remains within the target of 2-6% going forward. Moreover, five of the six members voted to explicitly state that the accommodative stance would continue at least during the current financial year, and into the next financial year.

The MPC had projected the CPI inflation to ease from 6.8% in Q2 FY21 to 4.5-5.4% in H2 FY21, with risks broadly balanced. Moreover, it had forecast a 9.5% contraction in the real GDP in FY21, with downside risks, projecting de-growth of 9.8% and 5.6%, respectively, in Q2 FY21 and Q3 FY21, followed by a marginal 0.5% growth in Q4 FY21.

Since the last review, the CPI inflation has hardened to a cringe-inducing 7.6% in October from 6.9% in Q2 FY21. With a contraction in GDP in two consecutive quarters, the Indian economy has entered into a recession in H1 FY21. However, the pace of contraction in India’s GDP (at constant 2011-12 prices) narrowed appreciably to 7.5% in Q2 FY21, from 23.9% in the lockdown-stricken Q1 FY21, and was narrower than what RBI and we had feared.

Several lead indicators recorded a spike in growth in October, which seemed to suggest that a sharp improvement had set in during Q3 FY21. However, this was exaggerated by restocking ahead of the festive season, and base effects related to a later onset of the festive period in 2020 relative to 2019. In our view, growth in many sectors may moderate in November, following some satiation of pent-up demand, as well as the temporary impact of a larger number of holidays. A clearer picture regarding the strength and durability of demand may emerge only in December.

The pace of central and state government spending in H2 FY21 remains to be seen, after the contraction recorded in Q2 FY21. Moreover, the economic recovery in many advanced economies has been disrupted with the reinstatement of restrictions amid surging Covid-19 cases, which may arrest the growth of Indian exports.

Amidst the continuing haze, we project the contraction in Indian GDP in FY21 at 7-9%, milder than our previous forecasts. However, the possibility of renewed restrictions necessitated by a rise in the Covid-19 infections remains a risk to the domestic growth outlook.

The supply-side disruptions in food, and other goods and services, issues related to the availability of labour, higher taxes on fuel and liquor, and elevated gold prices kept the headline CPI inflation at an uncomfortably high 6.9% in Q2 FY21. Looking ahead, the healthy kharif arrivals, favourable base effects, import duty cuts and a bright outlook for the upcoming rabi season should soften food inflation. The pace with which vegetable prices normalise would crucially affect the trajectory of food inflation in the near term.

Globally, crude oil prices may harden if there is further evidence that supports an early roll-out of a Covid-19 vaccine, which may impart modest pressure on retail fuel prices and the inflation outlook. With demand recovering, albeit at a variable pace across different sectors, and rising commodity prices, the core-inflation may remain sticky, despite the expectation of easing logistical disruptions.

We expect the CPI inflation to recede below the upper-end of the MPC’s target range of 6%, only in December, and average a substantial 5.3% in Q4 FY21. The inflation-growth dynamics suggest that we are close to the end of the rate cut cycle, with a slight possibility of a final cut in H1 FY22, followed by an extended pause.

So what about the accommodative stance? While inflation is expected to remain uncomfortable, the improvement in economic activity is nascent, and needs to be nurtured, warranting a continuation of the accommodative stance.

Equally significant are the persisting fiscal risks and the likelihood of a huge supply of state development loans, in addition to the issuance of Government of India securities (G-sec) of `2.3 trillion planned for Q4 FY21.

A new benchmark 10-year G-sec has just been introduced last week, the third in this fiscal year alone. This is the consequence of the massive G-sec issuance that has been necessitated in FY21, by the revenue shock generated owing to the Covid-19 pandemic. Given this context, the tone of the upcoming policy review is expected to remain fairly dovish, in an attempt to cap the yields.


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