RBI's approach to help set stage for a soft landing

With the government’s Budget being mostly as expected, the RBI, too, has stayed with the theme, with another, albeit smaller, rate hike. However, while this rate increase was expected, it was the hawkish tenor of Governor Shaktikanta Das that may have surprised the market. He reiterated that the RBI’s most urgent priority is taking inflation back to 4 per cent.

The caution around inflation risks is understandable. Through 2021 and 2022, the RBI had to face significantly higher inflation than its mandate, precipitating its most rapid monetary tightening since the new monetary framework was introduced in the early 2000s.

Further, there appears to be no real sense of an economic slowdown, with the global economic backdrop showing signs of improvement, and domestic consumption momentum appearing robust.

Further, central banks globally have continued to carry on tightening monetary conditions. This means that there is still almost a global consensus towards higher interest rates. This also means that the RBI would be generally looking at a higher cost of risk-free capital, which, while not critical for domestic funding, can influence behaviour of capital inflows, thus putting a premium on financing current account deficits.

However, there are reasons to be optimistic. The RBI’s forecasts appear very conservative, particularly on inflation. While it is correct that the bulk of the recent downward shift in inflation has come from volatile food prices, and core CPI appears to be quite persistent, we believe inflation will settle in the 4-5 per cent range, rather than the 5-6 per cent range.

This is without expecting retail oil prices to come down, and is driven by expectations of input costs and growth slowly moderating, which should help relieve upward pressure on output prices. The RBI has rightly chosen to wait and see inflationary trends if outturns move lower, and will want to see a reduction in the persistence of core CPI inflation, which has remained relatively sticky despite the fall in prices of domestic food and imported commodities.

This is perhaps also the reason why we are witnessing increasing variance within the MPC, as the relative concern around price stickiness, and the lagged and variable pass-through of the rapid monetary tightening seem to be sticking points for some members of the MPC. This is sensible because expectations of an economic slowdown are still baked in even though economic data, both globally and in India, is holding up.

The RBI’s caution on inflation and its relatively hawkish position demonstrate its steadfast commitment to achieving the inflation target of 4 per cent. But they do not preclude the RBI pausing if that target is achieved faster than the RBI itself currently expects. As such, we believe the need for higher rates is dissipating rapidly, because inflation appears set to fall to around 5 per cent by March 2023, and closer to 4 per cent by June 2023, barring any unexpected shocks.

Thus, the RBI’s prudent approach, aided by the more benign global backdrop, should help to set the scene for a soft landing later in 2023.

The writer is MD & head of EM Asia (ex-China) Economics, Barclays