INTERVIEW:Monetary policy hostage to health policy, says Nomura Varma

Informist, Wednesday, Aug 4, 2021


–Nomura's Varma: MPC should start focusing more on inflation now

–High inflation expectations weaken view CPI spike transitory


By Pragya Srivastava and Siddharth Upasani


NEW DELHI – India's monetary policy is hostage to the country's health policy, with the Reserve Bank of India being forced to continue with its expansionary policy for far too long, says Sonal Varma, Nomura's chief India economist.


"It is a very challenging period from the perspective of a central bank because monetary policy is now hostage to health policy," Varma told Informist in an interview.


"If monetary policy is too loose for too long in countries where inflation is not well anchored, inflation will become a problem as supply-side issues will feed into expectations and that ultimately becomes a demand-side problem," she says.


CPI inflation has come in above the Reserve Bank of India's mandated upper bound of 6% for two consecutive months now, with the unexpectedly high print of 6.30% for May forcing many economists, including Varma, to raise their inflation forecasts. 


Varma sees CPI inflation in 2021-22 (Apr-Mar) at 5.5%, 40 basis points higher than the forecast made by the central bank in June.


Despite the elevated inflation prints in recent months, RBI Governor Shaktikanta Das has maintained that the current inflation spike is "transitory", while the Monetary Policy Committee as a whole has reiterated its accommodative stance and its decision to maintain it "as long as necessary to revive and sustain growth on a durable basis".


This, for Varma, leaves room for many questions.


"What does 'sustain' mean? How many quarters of sustained growth, for instance? What is going to be the sequencing of normalisation on liquidity, the Liquidity Adjustment Facility corridor, on actual policy?


"If the MPC waits to give a signal when growth is already sustained, then the risk is that policy will be behind the curve."


Signals given by households' inflation expectations seem to indicate that monetary policy is already lagging. As per the households' inflation expectations survey released by the RBI, three-month and one-year-ahead inflation expectations were both up 70 bps from March at 10.8% and 10.9%, respectively, in May.


"Ultimately, the question for all central banks when they are trying to assess whether this is transitory or persistent is to monitor what is happening to inflation expectations," Varma said. "And for the last many household surveys now, there has been a gradual move up in inflation expectations. So, that actually goes a bit counter to the transitory argument that is being made."


As such, the central bank has perhaps reached a point where it might want to consider shifting some of its focus to inflation. According to Varma, the RBI does not want to be in a situation where it supports growth but exits the pandemic with an inflation problem.


Worryingly, even the pressures created so far by lockdowns are not fully dissipating.


"During the lockdown, in the first wave and now in the second wave, there has been a level adjustment up in prices," Varma pointed out. "And when the lockdowns ease, it (price hike) only partially reverses, and only in specific categories. So, we don't expect a full reversal to take place."


This warrants a closer focus on inflation than is currently being given.


"That's the balance which has to be found–when to start shifting the weights on inflation versus growth because the weightage assigned to growth has been quite high," Varma said. "Our assessment is that we are now at a point where, gradually, the weight assigned to inflation should increase."


While Varma agrees with the view that inflation is currently being driven by supply-side factors, demand-side pressures are bound to show up, with price pressures likely to shift from goods to services as the economy reopens fully.


The RBI's reliance on a favourable base effect pulling down inflation over the next few months is also troubling, with Varma concerned about the underlying inflation trend.


"Anchoring inflation to third-quarter (Oct-Dec) base effects is not appropriate," Varma said. "The reality is that inflation will rise again in the next quarter (Jan-Mar). So, what we need to really focus on is the underlying trend rather than a specific month or quarter."



This week, the Monetary Policy Committee is likely to retain the repo rate at 4.00%, continue with its accommodative stance, and not provide any guidance on policy normalisation.


Along with an upward revision of 40 bps to the CPI inflation forecast of 5.1% for this financial year, Varma sees much of the committee's focus being on qualitative assessment of inflation and growth, with the latest round of the household inflation expectations survey being crucial.


"If we have another round of increase in inflation expectations, the transitory argument will start being questioned," Varma said.


Varma expects a 75-bps hike in the repo rate in 2022, which would be par for the course if the output gap closes by the middle of next year and inflation is still high at 5.5%.


If the committee's meeting this week, which began today, might be too soon to set the ground for normalisation of monetary policy, Varma thinks subsequent meetings are "potentially open in terms of communication".


"Typically, I would say that a forward guidance of three-six months can help ensure there are no sudden shocks and the market is well-prepared," Varma said.


"August may be too soon, but I think at least discussions need to happen on this because the current guidance is that there is no thinking on normalisation at all."  End


Edited by Avishek Dutta


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