MPC to signal beginning of policy normalization in February

In October, the MPC unanimously voted to keep the policy repo rate at 4%. Amid a dissenting vote, it had decided to continue the accommodative stance for as long as necessary to revive and sustain growth on a sustainable basis and mitigate the impact of COVID on the economy, while ensuring that inflation remains within the target. As we anticipated, the RBI kept the reverse repo rate at 3.35%, while continuing to gradually normalize liquidity.

Arguably, the most important note of the previous policy review was that while production was lagging behind pre-pandemic levels, recovery remains uneven and depends on continued policy support. Q2FY22 GDP marginally exceeded pre-Covid levels, and the 8.4% pace of year-on-year (y-o-y) growth surpassed the MPC’s forecast of 7.9%. However, in our assessment, the individual data does not have concrete signs of sustainability, with both private and government consumption significantly lagging behind pre-Covid levels.

Also, after a largely healthy festive season, some indicators lost steam in November. The steepest drop in the daily average generation of GST (Goods and Services Tax) e-way bills fell to 2 million in November 1-28, from a record-high 2.4 million seen in October. In addition, fuel sales as well as port cargo traffic contracted year-on-year in November.

Substantial additional expenditure has been made on the second supplementary demand for grants recently submitted by the Government. 3 trillion, a part of which may be offset by savings under other departments. Despite this, the fiscal impulse of the new allocation is not uniformly growth-positive; For example, equity investments in Air India Assets Holding Ltd, as well as high fertilizer subsidies that became necessary due to skyrocketing prices.

Overall, with the renewed uncertainty generated by the Omicron version of COVID-19, we believe the MPC will leave its forecast of 9.5% of GDP for FY12 unchanged. In our view, recent data and developments do not suggest that the stability criteria of the MPC for changing the liberal stance to neutral have been met.

Besides, CPI inflation eased significantly below 5% in September-October, excise duty and VAT cuts on fuel have cooled prices, and rabi sowing intensified. At the same time, prices of staple vegetables have risen, and may remain uncomfortably high for a few months. In addition, producers facing margin pressure due to commodity prices and logistics costs have raised prices in several sectors.

We now expect CPI inflation to average 5.5% in FY12, higher than the MPC’s forecast of 5.3% in the October review. However, it is likely to remain within the medium term target range of 2-6% of the MPC.

Accordingly, we expect status quo from the MPC and RBI on stance and rates in the December policy review. However, with February’s policy review indicating an upcoming change in monetary policy stance to neutral, the tone is expected to harden until new lockdowns emerge again in the coming weeks.

We expect the stance to change with the RBI increasing the reverse repo rate by 15 basis points (bps) in February, thereby narrowing the policy corridor to 50 bps from the current 65 bps.

Thereafter, our base case continues to pencil in a 25 bps hike in repo and reverse repo rates each in the April and June reviews, followed by a reassessment of the sustainability of the growth revival as policy support is withdrawn. goes.

Aditi Nair is the Chief Economist at ICRA.