Inflation-Fed Tag Team To Keep RBI On Its Toes

The Reserve Bank of India finds itself in a dilemma between slowing economic growth and higher inflation tagged along with the US Federal Reserve set to tighten policy this week.

India's latest inflation data showed price pressures rose a touch further in February to above the Reserve Bank of India's upper end of the 2-6 per cent target band for a second straight month. That was even before the impact was felt of the Russia invasion of Ukraine on February 24.

Data showed the trade deficit widened to $17.94 Billion in February, with higher fuel import bills taking the lion's share, suggesting a further widening from the rise in global energy prices on supply concerns.

That does not cover the surge in crude prices to above $100 a barrel and the spike in costs of a broad range of commodities, driven by supply concerns after Western countries' sanctions and oil import embargo on Russia in response to its invasion of Ukraine.

With the disruptions to lives and livelihoods of the pandemic just about waning, soaring energy prices and rising inflation - which typically hurt household spending, provides little cushion for consumers.

While the latest inflation reading has not convinced economists that the RBI would be veered off its growth support policy course, an increasing number now expect the central bank to consider policy tightening, albeit at a slow pace.

"With the spike in global crude oil prices and continuing uncertainties, including supply-chain disruptions due to the ongoing war in Europe and economic sanctions, the outlook for inflation remains uncertain," said analysts at Anand Rathi.

"The government can, for now, limit the pass-through of high oil prices. Yet, this might turn out to be challenging if the situation persists or the rise continues. We expect the RBI to follow global cues and start raising policy rates, but moderately," they added.

What will also pressure the RBI is the rate hike trajectory of the US Federal Reserve. 

The Fed is all set to raise rates for the first time since the pandemic at its meeting, which concludes Wednesday, with market participants looking for indications about the pace of future rate hikes. 

Markets anticipate a 25 basis point rise at this meeting, according to the Chicago Mercantile Exchange's (CME) Fed watch tool. Still, pricing has risen to indicate a 70 per cent chance of a more significant 50 basis point hike at its subsequent meeting in May due to concerns about inflation.

According to the latest data, inflation in the US jumped to its largest in 40 years. That is likely to fuel a more aggressive Fed stand.

"We think the statement and Chair (Jerome) Powell's press conference after the meeting will be influential in terms of market pricing for a 50 basis point rise in May and beyond...," Carol Kong, an FX strategist at Commonwealth Bank of Australia (CBA) told Reuters.

Last year, most major central banks termed inflation as transitory, including the US Federal Reserve, but have had to make a U-turn on those expectations and recognise the risks of runaway inflation since the turn of the year.

While the Fed has been signalling tighter monetary policy for months, the RBI has repeatedly said it is focussed on supporting growth.

"Damned If It Does, Damned If It Doesn't"

The real worry is the dilemma the RBI faces.

"With the crude oil prices breaching $100, and fuel price hike due after elections, inflation may continue to remain above the 6 per cent level for the next few months. In the upcoming bi-monthly meet, RBI may have to depart from its accommodative stance and take action in line with major central banks,” said Raghvendra Nath, Managing Director – Ladderup Wealth Management.

Supply-driven inflation has been India's bane for years before the pandemic, and with most parts of the country opening up and easing COVID-19 restrictions, the demand is expected to rise.

Price pressures have risen globally, driven by the pandemic-led supply disruptions, which do not seem to disappear anytime soon.

"The RBI will be damned if it does, and be damned if it doesn't," said an analyst at a large trading firm in Mumbai.

While a section of economists predict the central bank will and has to look through higher inflation reading, another set predicts the RBI is behind the curve and will be forced to tighten policy too much, too fast, which could push the economy into a recession.

In late February, when asked if the RBI was behind the curve on inflation, Kunal Kundu, India economist at Societe Generale, said, "we believe it is. The persistence of elevated inflation is a reality and is difficult to be wished away by not acting. The central bank's rather benign inflation forecast for FY23 is in sharp contrast to street expectations and suggests the likelihood of delayed action."

"But we see multiple pressure points building up which would keep inflation quite beyond 5.0 per cent next year. The potential price for delayed action could be an aggressive rate hike at a later stage, which could come at the cost of economic recovery," he added.

RBI deputy governor Michael Patra, speaking on a central banks panel discussion at the Asia Economic Dialogue, said, "Our sense is that headline inflation has peaked in January, and from hereon it will ease down to the target of 4 per cent by the last quarter of 2022."

Mr Patra suggested expectations that India is behind the curve on withdrawing monetary stimulus is unfair, especially after the deep global recession led by the pandemic and that support for economic recovery is still warranted.

Still, global price pressures will remain high on the surge in oil costs. While India's inflation may have peaked, expectations remain for price pressures to hold high this year.

"Given the current trajectory, the RBI is correct. It will peak during this quarter. The important point, though, is the easing trajectory. Currently, it is above the upper band of RBI's rather wide comfort zone. So, peaking of inflation in itself is not too comforting," added Mr Kundu.