RBI’s challenge is steepened by a new matrix of global uncertainty

So, what is the Reserve Bank of India (RBI) likely to do amid these varying signals? Its decision will be difficult in this uncertain global and domestic environment. Let’s take a closer look at some of the factors that will have a bearing on RBI’s decision. The most critical factor would be inflation. Retail inflation for the last two months has been higher than 6% (RBI’s upper tolerance limit). The rise was led by food and non-food components. Food inflation contributed around 44% to overall inflation in the last two months, with cereal inflation spiking to above 16%. Worryingly, the core remained sticky above 6%.

While inflation in the last few months has been above RBI expectations, we expect it to moderate in the next few months, supported by the base effect. Food inflation is also likely to cool off, based on expectations of a healthy rabi harvest. But again, we need to be cautious of weather-related disruptions and their adverse impact on food prices. The threat of El Nino or severe heatwaves could further complicate inflation management. As far as core inflation is concerned, which has broadly remained above 6% for 2022-23, it will take time before we see a moderation in response to the monetary policy tightening so far and fizzling out of pent-up demand. Based on the assumption of a normal monsoon and no major rebound in global commodity prices, average retail inflation is likely to moderate to around 5.1% in 2023-24. Core inflation will also moderate, but is likely to remain above 5% over the new fiscal year.

Coming to growth, if we look at the last few data points emanating from India, we are seeing mixed signals. While indicators like GST collections, e-way bills, bank credit demand, passenger car sales, services GVA (gross value added) are still showing a robust recovery, other indicators like manufacturing GVA, PMI manufacturing and exports are showing signs of weakness. Corporate performance is also showing signs of moderation. Our study of 2,200 listed non-finance companies showed that sales growth moderated to 15% in the third quarter of 2022-23 from 26% in the second quarter. There is no denying that with global growth slowing down in 2023, India will feel the pain. Moreover, the strong pent-up demand seen specifically in the contact-intensive services sector could fizzle out in the months to come. However, with India’s economy still likely to record around 6% growth in 2023-24, the central bank will not be overly concerned about expansion. Having said that, there is a need to exercise caution as the economic environment remains quite uncertain. Two MPC members have already been highlighting the risks of RBI overshooting with rate hikes.

The risk of any spillover from the global turmoil on India’s economic recovery cannot be ignored. Global growth is slowing down, and we are already seeing the adverse impact of that on our exports. The recent collapse of two banks in the US and Credit Suisse in Europe has heightened risks of financial turmoil, which could snowball into a deeper global slowdown. While the problem has been contained for now, India needs to remain vigilant on the likely ripple effect from any global escalation.

Our goods exports are feeling the pain of a global slowdown and contracting on a year-on-year basis. However, imports are also moderating, which has resulted in narrowing the country’s trade deficit. Moreover, the services sector recorded robust exports growth of 30% year-on-year in much of 2022-23, cushioning the impact of falling merchandise exports. With robust services sector export, strong remittances and moderating imports, we expect the current account deficit (CAD) to GDP ratio to fall below 2% in 2023-24. Likely CAD moderation and sufficient foreign exchange reserves will reduce our external vulnerability.

Nevertheless, RBI has a challenging task in hand with inflation still high, domestic growth showing some signs of moderation and heightened global economic uncertainties. Central banks globally and in India were slow to react to the post-pandemic inflationary threat. Having learnt their lessons, central banks are now wary of giving conflicting signals to the market.

Even with heightened financial sector risk, the US Federal Reserve hiked the Fed funds rate in March and is likely to hike it further in its next policy meeting. Other major central banks, like the European Central Bank and Bank of England, are also likely to hike policy rates further as inflation remains high.

It is difficult for RBI to halt and see the impact of monetary tightening so far. Hence, India’s central bank may choose to hike its policy rate one more time in the MPC’s April meeting, before hitting the pause button in this cycle. With banking system liquidity already having tightened, RBI is also likely to change its stance to “neutral” from “removal of monetary accommodation.”

Rajani Sinha is chief economist, CareEdge