RBI MPC - Thinking Through India’s Inflation Dynamics And Policy Response - JPMorgan

03-06-22 → Confronted with extraordinary global price pressures, fiscal and monetary policy in India will have
to reinforce each other to ensure that inflationary impulses and expectations don’t get more entrenched and generalised.

After India’s headline CPI surged into the 7% handle in mid-April, there have been a flurry of fiscal and monetary responses to combat
price pressures. An inter-meet rate hike and draining of liquidity, an unwinding of duties on petroleum products, exports bans, and
import tariff cuts. The unwinding of excise duty hikes—even as they accentuate fiscal trade-offs—is
understandable, because food and fuel prices are important in the formation of household inflation expectations. To the extent that
these steps arrest, or even temporarily reverse, retail fuel prices, they may have a salutary impact on expectation formation.

Complements, Not Substitutes The price action across some rates markets that followed the fiscal actions
seemed to suggest market participants believe fiscal actions can potentially substitute for necessary monetary policy tightening.

In our view, however, fiscal and monetary policy will need to be

complements, not substitutes, in this cycle. This is because inflation has
become increasingly generalised. In April, prices of almost 60% of the
300 items in the CPI basket were growing at an annualised monthly
momentum of over 6%. This used to be less than 30% back in 2019.

Trimmed-mean measures of inflation are tracking between 6-7% – almost

200 bps higher than just a year ago – in sympathy with the trajectory of
underlying core inflation. The top 20% of inflation-contributing items
typically account for almost 45% of overall inflation (5-year pre-pandemic
average). Over the last 3 months, they account for about 25%.

Therefore, any which way one cuts the basket, price pressures have
become more generalised, with 2nd-round effects beginning to take hold

Against this backdrop, targeted fiscal actions in a few sectors may

not be enough. Instead, monetary policy will have to temper demand
to ensure second-round effects don’t get more entrenched.

The challenge is that cost pressures have been unrelenting,

reflected in the composite PMI input price index for April rising to
its highest level in 12 years. To be sure, recent measures on fuel and
steel will provide some cost relief, but with Chinese growth recovery
expected to push up commodity prices further, there appears to be
little relief in the near term. The worry is that firms will eventually
have to pass these on, to avoid further margin compression.

Manufacturing firms have been able to pass most cost increases through, but service sector firms have only passed on about a half.
That could be the next shoe waiting to drop, as the services economy continues to recover from the pandemic.

This is where the stance of monetary policy, and its impact on demand, could help influence how much of this is eventually passed on. To
be sure, fiscal policy will have to play its part, too, in slowing second-round effects by tempering the increase in MSPs, minimum wages,
and dearness allowances to prevent a food-wage-price spiral from developing. All told, fiscal and monetary actions will need to reinforce
each other, given the scale of the challenge currently confronted. Even accounting for this, though, we
expect full-year FY23 CPI to average about 6.7%, with the 1st half expected to average 6.8%, and the 2nd half about 6.5%.

Your Inflation, My Problem Stepping back, one can legitimately ask whether monetary policy should be reacting to a supply
shock in the first place? Much of the recent surge in inflation is on account of the surge in global commodity prices over which Indian
policymakers and monetary policy, in particular, have little control. Why tighten monetary policy and temper demand, when India’s
economic recovery from the pandemic remains incomplete? One argument revolves around the evolution of inflation
expectations. The latter tend to be adaptive, reacting to experienced inflation. The supply shock that many emerging markets have
confronted is not temporary, but has now lingered for more than 2 years, first in the form of disrupted global and supply chains and now
the commodity surge from the conflict. In India’s case, headline CPI has averaged 6% since the start of 2020. Given
their adaptive maturity, inflation expectations have unsurprisingly hardened over the last two years, with inflation expectations of
businesses (IIM Ahmedabad Survey), currently at their highest level since the inception of the survey five years ago.
 Hardening inflation expectations worsens the trade-off
between slack and prices. In economics jargon, the Phillips
Curve moves up. For any level of slack, economic agents have to
live with higher inflation. Conversely, to achieve a certain level
of inflation, the economy must live with more slack.

That’s why it’s imperative to front-load monetary policy (more

of that below) to tame price pressures and ensure that adaptive
expectations don’t harden further.

To be sure, a hardening of interest rates amidst an incomplete

economic recovery from the pandemic is not ideal (as the latest
GDP print revealed, the level of GDP is still about 6% below its
pre-pandemic trend). But rates will go up, whether fiscal or
monetary measures are used. Fiscal measures that increase the
odds of a wider deficit (and more market borrowing) will increase uncertainty and risk premia at the long end, resulting in a “bear
steepening” of the yield curve. In contrast, monetary policy tightening will result in a “bear flattening” of the curve. In both cases,
yields go up, but to different degrees along the curve. There is no free lunch.

What Does Taylor Think ? Even if there is broad agreement on the need for some monetary tightening, the question that
markets and analysts are grappling with is what should/will the RBI’s terminal rate be in the current cycle? Like in the case of other
central banks, this is a daunting question. Estimating neutral policy rates is challenging at the best of times, but especially herculean at
the moment given the potential structural changes the pandemic may have triggered. However, if one were to combine
(i) the RBI’s stance in the February reaction function where inflation was expected to slow towards 4% and it believed extant rates
were appropriate, with (ii) the current outlook for growth and inflation; and (iii) the parameters of its policy reaction function recently
analysed in a published article, one can begin to reconstruct the central bank’s Taylor Rule which would suggest a terminal rate in the
vicinity of 6%, similar to the Taylor Rule that we estimate. (For more details of these computations, refer to this Technical Annexure.)

Will This Be Enough ? The Taylor Rule estimation, however, only reveals what the central
bank may do based on history. It does not necessarily tell us whether this is enough or whether a structural break could be underway
(i.e. a hardening of expectations is forcing a change in the Taylor Rule coefficients). If the Taylor Rule is followed, contemporaneous
real rates will still be negative toward the end of this fiscal year. Will this be enough? Recall that in the year before the pandemic, the
contemporaneous real rate averaged 1.5%. So will real rates have to end up higher? Or have neutral rates fallen even more during the
pandemic? These are known unknowns, and the central bank will eventually have to cross the river by feeling the stones.

A Stitch In Time Whatever the final terminal rate the RBI seeks to achieve,
the key will be to front-load monetary normalisation off very accommodative starting points, for at least two reasons :

1st, if the idea is to tame inflation expectations, and expectations are a function of realised inflation, the central bank should try and
bring down inflation as soon as possible. With every quarter that inflation, and therefore expectations, stay elevated, the trade-off
between slack and prices gets worse. 2nd, the slower any central bank proceeds with normalisation, the more expectations build-up
for future rate hike increases (the catch-up that markets assume will eventually be required) which ends up steepening the yield curve.

As past experience has shown, a steeper curve can increase financial stability risks with economic agents incentivised to borrow short
and keep rolling over their liabilities to avoid higher rates at the longer end, thereby reducing the maturity of their liabilities and
exposing themselves to more roll-over risk. What does this imply for the current cycle ?

On the back of the 80 bps hikes since April, we expect the RBI to hike about 75 bps over the next two meetings,
though we remain agnostic about the distribution across the two meetings.
Once the pandemic accommodation is withdrawn, we expect the MPC to move in more conventional increments of 25 bps.

Connecting The Dots : Communication And Risk Premia

The challenge for the RBI will be to front-load monetary normalisation without spooking the market about what it implies for the
terminal rate. The risk is the faster the RBI moves, the further the market presumes the central bank needs to go.

After the surprise inter-meeting hike, the OIS swap curve hardened by almost 100 bps in a day, and is now pricing in a terminal rate of
7%. How then can the RBI convey that speed does not necessarily equate to the distance that needs to eventually be travelled ?

One straightforward way is for the MPC to provide more quantitative forward guidance in the form of a conditional dot plot, like what
the Fed offers. During a time of such extreme uncertainty, this should anchor expectations of where the RBI plans to go (conditional,
of course, on economic outcomes) thereby allowing the RBI to remain nimble about the pace of its normalisation without disrupting
terminal rate expectations. More generally, anything that emerging market central banks can do to reduce uncertainty –
either through quantitative forward guidance or moving in more conventional clips of 25/50 bps – can help reduce risk premia embedded
in interest rates, and facilitate a more orderly normalisation. All told, confronted with extraordinary global price
pressures, fiscal and monetary policy in India will have to work in tandem to ensure that inflationary impulses and expectations
don’t get more entrenched and generalised, even as they remain mindful of nurturing India’s recovery from the pandemic.