Another rate hike may be in the offing
If economic activity is sustained at an elevated level and pricing power is high, RBI has a longer runway to land its rate hikes. But this does not mean the bank will keep circling, lest the fuel in the economy runs out
As the dust settles on January’s inflation (which rose to a three-month high at 6.52%) data debate, an old question has popped up: Is the Reserve Bank of India (RBI) behind the curve in its fight against inflation? This comes when the fixed-income markets have priced-out rate hikes, and analysts concluded that RBI was done with the rate-hike cycle. This view was doing the rounds despite the hawkish commentary in RBI’s last Monetary Policy Committee (MPC) meeting.
Before the MPC outlook, let us examine what happened to inflation. Through 2022, even as inflation expectations rose quickly for consumers and businesses due to the Ukraine conflict, the consumer inflation data peaked in April, as the government unveiled fiscal policies to shield consumers from higher prices. In addition, the downtrend in global commodity prices that began in September 2022 translated into a sharp decline in imported and wholesale inflation in India. Consequently, this reduced pressures on the public purse, though the financial savings have yet to be fully passed on to consumers. The government needs to shore up public finances to run its welfare programmes.
However, a gap is now opening between wholesale prices and consumer prices. So, which way is inflation headed, up or down? At this point, it is worth differentiating between price pressures faced by consumers and businesses.
Let’s first look at the business side. Most business inflation surveys, including the one undertaken by the Indian Institute of Management-Ahmedabad, point to a significant decline in business inflation expectations, aided by declining input costs. In RBI’s industrial outlook survey, the cost of raw materials is no longer as big a drag as it was a few quarters ago. Within the services outlook survey, selling prices have increased, consistent with the Purchasing Managers’ Index data, and profit margins have widened after shrinking for a few quarters.
While disinflation in business costs reduces the input cost pass-through impulse and possibly supports business profits, the reality for consumers differs.
Increases in specific food prices, such as cereals and milk, are likely to outweigh the falls in prices of vegetables, cooking oil and eggs, at least in the perception of a generalised increase in food prices rather than the reality of the food price index being flat since August last year. This also comes when the safety valve of food stocks has been impacted, and higher global food prices are seeping through the gaps as exports and farmers gain from it.
So, while consumers can take comfort that retail prices do not have the same force multipliers to push them higher, in contrast to the situation in early 2022, they are also unlikely to benefit significantly from the disinflation in goods inflation, as producers retain their pricing advantage.
This is not necessarily a negative factor for the economy. Before the budget, there was a small but spirited debate on the right level of nominal Gross Domestic Product (GDP) growth for India. We have always viewed this as not solely a question of the deflator or real GDP growth but rather a split between the two factors, as given the cost structure of the economy, profit increases or declines can shape growth in the real economy, thus making the process more endogenous than previously. Put simply, if businesses are making more profits, and some consumers, i.e. those in the agriculture sector or services, are seeing pricing power, this should drive consumption for businesses and the agriculture-driven rural sector, since they do not operate in an economic vacuum.
This means that if there is a certain degree of pricing power in the economy, this is likely to reflect robust growth momentum. This may weaken in the coming months as the compounding effect of high-interest rates, tight banking sector liquidity, and a loss of global GDP momentum pushes growth somewhat lower. This also means that the fading in pricing power will likely become more visible. Hence, inflation should slow along with growth, rather than the two metrics operating as two mutually exclusive outcomes with no real connective tissue between them.
What does this mean for monetary policy? The upside surprise in January inflation, coupled with a more hawkish set of minutes from MPC members, shifts the balance of risks for the MPC going forward.
As a result, we think a rate hike in April has become the more likely outcome, with the voting pattern to be split 3-3 or 4-2. However, greater pass-through of lower fuel prices through policy actions could change things.
If economic activity is sustained at an elevated level and pricing power is high, RBI has a longer runway to land its rate hikes. But this does not mean the bank will keep circling, lest the fuel in the economy runs out, resulting in a hard landing.
Rahul Bajoria is managing director and head, EM Asia (ex-China) Economics Research, and Shreya Sodhani is regional economist at BarclaysThe views expressed are personal