The decks were cleared for some monetary policy normalisation, possibly with a reverse repo hike in the December policy. A decent growth pick-up, inflation pressures resurfacing, and markets adjusting to higher short-term rates had made it easier for the Reserve Bank of India (RBI) to take the first steps of policy normalisation. However, uncertainty due to the latest Covid variant, Omicron, will likely keep the RBI in wait-and-watch mode while signalling policy and liquidity normalisation based on the evolution of the Omicron variant.

Economic revival taking root

The MPC goes into the December meeting with:

2QFY22 real GDP growth at 8.4 per cent against its estimate of 7.9 per cent.

Sequential pick-up in October retail prices and core inflation staying high.

Activity indicators continue to indicate that most sectors are back to pre-Covid levels (some higher too), and contact-based services also gradually ramping up.

The domestic economic conditions point at a revival starting to take steady roots. However, any change in repo rate and the accommodative stance in the MPC’s ambit is still some way off. The MPC would continue to wait for a more broad-based durable growth pick-up before the last piece in policy normalisation, the repo rate, is hiked.

Omicron shadow looms over oil, gas prices

Over the last two policies, the amount under VRRR has been increased in a staggered manner. Higher cut-offs in the VRRR auctions amidst moderation in surplus liquidity have pushed money market rates higher. While overnight money market rates have hovered around the reverse repo rate, the term money market rates have moved in line with the weighted average reverse repo rate in sync with the VRRR cut-offs. Short-term rates, in general, had hardened, indicating the markets have priced in some rate normalisation by the RBI.

External financial conditions have also started turning averse. The Federal Reserve has started tapering its asset purchases. The Fed minutes and recent testimony by Fed Chair Powell indicated that the Fed is looking at a faster pace of taper. Markets are expecting a rate hike as early as June 2022 as well as a faster pace of rate hikes. Some of the emerging market central banks have embarked on a rate hike cycle, while some of the other developed market central banks are starting to turn.

RBI and inflation management

Globally, price pressures and supply disruptions have continued. Domestic manufacturers across sectors have taken price hikes though the pass-through remains incomplete. Core CPI inflation at 6 per cent remains sticky, and we expect it to glide down very gradually over the rest of FY2022 and FY2023. Even as headline inflation has dipped over September and October, there has been some sequential increase in food prices though it should be short-lived.

Despite Omicron, India's economy remains on a recovery path: NIBRI

While excise duty cuts on petrol and diesel would ease inflation by 35-40 bps, higher mobile phone tariffs would offset much of the fuel price-led fall. Further, as services recover, inflation could see some upside from services inflation which forms around 25 per cent of the CPI basket. Over the medium term, headline inflation is unlikely to reach the 4 per cent mark durably, especially if global commodity prices remain high. The RBI would aim to keep inflation expectations under check given the adaptive nature of expectations formation. 

Keeping in view these factors, it would be opportune for the RBI to start reversing the excesses of the pandemic. To that extent, raising the reverse repo rate would be the first step in the December policy. However, the impact of the new Omicron variant remains unknown and details will emerge over the next few weeks.

Amongst the initial data, the pace of increase in Covid cases in South Africa would warrant caution. While market interest rates movement would warrant minimal disruption due to reverse repo rate hike, the uncertainty of a further Covid wave and its economic impact would be a deterrent for moving on rates. While the December policy remains a live one, we expect the RBI to remain in a wait-and-watch mode while signalling that it is on a path of normalisation.

The author is Senior Economist at Kotak Institutional Equities. Views expressed are personal.