As growth strengthens and the RBI’s inflation-targeting credibility comes under greater scrutiny, a policy pivot would become increasingly likely.
Within a span of a few months, India has transitioned from facing a shortage of hospital beds to showing off crowded holiday resorts. Fresh out of a deadly second wave, viral videos of clogged roads to hill stations and packed markets are symptomatic of the rapid recovery in economic activity as the worst of the lockdown restrictions have ended.
Growth indicators so far suggest a “Teflon economy” in the short term — a shallow dent in May’s economic activity followed by a recovery in June, back to April’s levels. The external, investment and industrial sectors have been relatively resilient, with consumption and services bearing the brunt. Notwithstanding signs of some fatigue in ultra-high frequency indicators in July, damage from the second wave seems largely limited to April-June 2021.
Nevertheless, a K-shaped recovery means light cracks on the top conceal much larger structural faultlines below. The Pew Research Centre estimates that the pandemic has led to India’s poor rising by 75 million, while the middle and upper-middle class has shrunk by 39 million. A recent survey by the ILO finds that the worst-hit — MSMEs and their informal workforce — have struggled to access the government’s pandemic support programmes. These more structural scars may become blurred in the GDP data in coming quarters as the economy rapidly normalises alongside strong global growth, fiscal activism, and easy financial conditions, but will almost certainly affect the medium-term growth story.
However, in the near term, there are two impending macro pivots to navigate. First, is the vaccine pivot. The “ultimate unlocking” of the economy remains contingent on a critical mass getting vaccinated, which on materialising should trigger a revival in consumer and business sentiment. The vaccine pivot is also an effective insurance policy against a possible third wave — a risk to near-term growth. The lacklustre pace of vaccination in July and fresh information on the vaccine pipeline suggest that there are risks of a delay in the pivot taking place in August, and to our baseline projection of around 50 per cent of the population being vaccinated by end-2021. However, the uptick in the pace of vaccination over the last few days and higher seroprevalence reported in some states are welcome news.
The second pivot is that of policy. When inflation is under control, then flush liquidity and ultra-accommodative monetary policy will help kill two birds with one stone — ensuring easy financial conditions, and helping control borrowing costs of the government’s expansive borrowing programme. However, this strategy is not costless. It effectively uses the central bank’s credibility in controlling inflation as “collateral”. So when inflation flares up and remains sticky, this arithmetic becomes increasingly complicated.
The RBI’s consistent message recently has been to view the current inflation surge as a “temporary hump”. However, CPI inflation is tracking 5-6 per cent on an already high base of 6.6 per cent in 2020, amid elevated inflation expectations, ongoing supply-side shocks and imminent demand-side ones. We believe these factors should have ordinarily led to monetary policy alarm bells ringing. But as Governor Shaktikanta Das recently commented, “It is not like any other year, when inflation goes up, you start tightening the monetary policy”.
But maybe that year is coming to a close, although not at the August policy meeting later this week. Despite our expectation of the RBI revising up its CPI inflation projection higher by 40 basis points, the message is likely to be that this is not a monetary policy game-changer. Instead, we expect a message on the lines of inflation remaining supply-side driven, the economic recovery still requiring policy support, and bond yields still needing to be kept under control.
Much as the current monetary policy stance maintains that the economy is ill-equipped to handle policy normalisation, it is a matter of when rather than if. As growth strengthens and the RBI’s inflation-targeting credibility comes under greater scrutiny, a policy pivot would become increasingly likely. In our baseline projection, we expect a 40 basis point reverse repo rate hike in Q4, and then cumulative hikes of 75 basis points in 2022.
The broader, and probably trickier issue for central banks, governments, and indeed the public is how to live with “long Covid”. Even with widespread vaccinations, future pandemic waves may well be unavoidable. Fiscal, monetary and administrative policies cannot remain in a suspended emergency.