Central Banks across the globe have turned from being dovish to hawkish, thanks to the spiraling inflation. The Russia-Ukraine war has worsened the inflation dynamics due to supply side disruptions in commodities. Crude oil prices have surged past the $100 per barrel mark and continues to remain sticky. Agri commodity prices too have been impacted amid war-led shortages, climate disruptions, fertiliser shortages and inelastic demand. Consumer inflation in US touched a 41 year high at 8.5% in March. The picture is similar across the globe with inflation touching multi decadal highs. The resultant impact is on real interest rates which turned negative across most economies.  

With inflation breaching the tolerance limit, central banks were left with no option but to firefight the inflation woes. Clearly, inflation had to take the centre stage while growth recedes in priority. A clear trend of rate hiking spree has emerged across developed as well as developing economies with a few exceptions like China. The real interest rates are still quite negative in developed economies and a few developing economies implying that central banks would have to raise rates further to align interest rates with inflation expectations. 

The RBI’s inflation forecasts have changed considerably over the past two policy meetings, which suggests the need to front-load rate increases. It raised repo rate by 40 basis points (bps) to 4.4 per cent and CRR by 50 bps to 4.5 per cent in an off-cycle policy meeting in early May. While the market participants were expecting the repo rate hike, what surprised the market was: a) Timing, b) Magnitude of the hike (40bps) c) Repo hike accompanied by CRR hike. CRR hike is expected to withdraw liquidity to the tune of ₹87,000 crore. Despite the CRR hike, the net liquidity in the system is likely to be comfortable for now.  

The hike in repo rate is aimed at anchoring inflation and improving the medium term sustainable and inclusive growth prospects of the economy. This was on the back of downward projection of global growth, shortages, volatility in commodity and financial markets as well as inflationary pressures, which are becoming more acute.  

The Overnight Index Swap (OIS), which is a dependable way to gauge future repo rate, has been hinting that the repo rates are on the way up. One-year OIS is factoring in around 2 per cent rate hike over one year. The market consensus too is that the RBI would further front load rate hikes. The bond street is expecting 75-100 bps rate hike till December 2022 and another 100-125 bps next year. The next monetary policy decision is scheduled to be announced on June 8, 2022 and it is expected that the RBI would continue to front load the rate hike with another 40-50 bps hike. 

Coming back to the root cause of the policy tightening (inflation), in our base-case scenario, we expect CPI inflation well above the RBI’s upper limit of 6%, over the next 2 quarters before inflation starts to taper down on high base of 2HFY22. 

Key Risks to inflation 

Food is a large component of India’s CPI basket and a weaker-than-expected monsoon may drive up food prices over the next few months. The Indian Meteorological Department (IMD) predicts a normal monsoon for CY2022 but we note that weather patterns have become quite erratic. For example, higher-than-normal temperatures in the months of March and April affected the yield of India’s wheat output in the recent rabi (winter) season and also, production of vegetables. As a result, food inflation has increased over the past few months, although, the bulk of food inflation is due to seasonal crops such as fruits and vegetables. 

Russia is a meaningful exporter of crude oil and refined products. Energy prices may spike further if all or a meaningful portion of Russian energy exports were to be removed from global energy markets, forced by (1) further economic sanctions of the US and Europe against Russian banks, financial system and energy sector and (2) voluntary embargo by EU of Russian crude oil and gas. The EU recently decided to embargo sea-borne cargoes of crude oil and allow only crude exports through pipelines to certain land-locked refineries in eastern Europe. 

Tepid growth momentum 

Growth momentum on the contrary remains tepid. 4QFY22 real GDP growth print slowed down from the previous quarter at 4.1%. This was partly led by the temporary restrictions imposed to tackle the spread of the Omicron variant in January. The near-term outlook remains uncertain due to the ongoing geopolitical conflicts, weakening global demand, limited scope for incremental government spending, and tightening financial conditions.  

The recent fiscal measures on excise duty and food import/export related measures should partly alleviate the eroding purchasing power of consumers. However, continued elevated input prices and the expected pass-through risks are encroaching on growth.  

While the high frequency data shows some emerging strength in contact-based services, demand revival will remain a concern. Our estimated growth trajectory will be shaped by (1) weakness in consumption demand given impact of cost-push inflation, and weakness in broader labour market, (2) delayed pickup in private sector investment given relatively weaker demand visibility along with increasing cost of borrowing, (3) limited ability of central and State governments’ expenditure on public infrastructure, and (4) weakening global growth. 

Given the current dynamics, the bond markets may have downside risks if inflation were to surprise negatively over the next few months on higher-than-expected domestic food prices and global fuel prices. The government’s fiscal position has worsened significantly since it presented its FY2023 budget on February 1, 2022. Street expectations of (1) higher-than-expected revenues have been opposed by the government’s compulsion to reduce excise duties on diesel and gasoline to manage runaway inflation and (2) manageable expenditure intercepted by steep increase in government subsidies on food and fertilisers. RBI and the Government are walking on a tight rope to balance growth and inflation dynamics and would aim for a soft landing amid raising interest rates to curb inflation. 

The author is CIO – Debt & Head – Products, Kotak Mahindra Asset Management Company. The views expressed in the column are personal and do not necessarily reflect the opinion of the organisation or the Kotak group.

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