Is India's central bank risking a taper tantrum?

India’s central bank, the Reserve Bank of India (RBI), has looked past relatively high inflation in order to support economic growth through the pandemic. But with activity now recovering, there are signs that policymakers are thinking about withdrawing liquidity and normalising interest rates from record low levels.

The RBI has signalled that this will be very gradual, but inflation is already relatively high. For investors this risks a tantrum in the bond market, which would undermine the expensive valuations seen in the equity market.

What is driving higher inflation in India, and will it be sustained?  

The latest data showed that headline inflation fell by 0.3% to 5.3% year-on-year, mainly driven by a cooling in food prices. Inflation breached the RBI's tolerance level of 6% in May and although it has since come down slightly, it remains above the inflation target of 4%.  

Underlying price pressures are also above target. Core inflation, which is slower moving as it strips out the volatile impact of food and energy price changes, is running at 6%, as this next chart shows.

The rise in inflation has been predominantly supply driven; high commodity prices have pushed up fuel, light and transport inflation while supply disruption has raised wider price pressures.

Going forward, we expect inflation to fall to 5% by the end of the year, but stay above target. Given the annual comparisons of commodity prices in inflation, base effects of low oil prices last year should now wash out, therefore becoming disinflationary. This should reduce energy related inflation, which also comes through to core inflation via transport.

Supply side interventions from the government, and a relatively normal monsoon rain season, should keep food prices under control. Meanwhile broader supply should also improve as the economy recovers. Ultimately this reflects a still relatively large amount of slack in the economy. Our estimates suggest that the output gap is in the range of 4-6% of GDP, after the economy contracted by -12% in the second quarter.

However, we estimate that the output gap should close around the middle of next year; around the same time India is anticipated to reach herd immunity to Covid-19 through vaccinations. A further recovery in activity is then likely to create excess demand and lead to more sustained price pressures, particularly in 2023. 

How the central bank responded to pandemic-induced challenges

Lockdown-induced weak growth and high inflation has posed a conflict to India’s central bank. Policymakers clearly focussed on growth rather than inflation: the RBI’s policy stance is still “accommodative” and specified to continue “as long as necessary to revive and sustain growth on a durable basis”. Indeed, Governor Das noted in the latest central bank monthly bulletin that the RBI is still in “whatever it takes mode”. This seems to reflect an India still in crisis, given these words used by the former European Central Bank governor, Mario Draghi, in the midst of the 2012 eurozone crisis.

India was already facing fiscal constraints before the pandemic began, leaving the central bank to do a lot of the heavy lifting to support growth when Covid hit. With India’s economy already slowing, the RBI was forced to restart its interest rate cutting cycle; it lowered the benchmark repo rate by 115bps to a record low of 4%. This plunged the real interest rate, adjusted for inflation, into negative territory as seen in this next chart.

The RBI also eased monetary policy using unconventional tools. It announced a series of Targeted Long Term Repo Operations (TLTROs), committed to buying 2.2 trillion rupees of government bonds under its Government Securities Acquisition Programme (G-SAP), and sought to manage the yield curve through an Indian version of Operation Twist. Various monetary policy measures have resulted in a banking system that is awash with liquidity, running at a daily surplus of 8.2 trillion rupees.

Signs of a shift towards tightening – but normalisation set to be gradual

All six members of the monetary policy committee voted to keep the headline repo rate on hold at 4% in the August policy meeting. However, there were various signs that suggest the central bank is getting ready to reduce liquidity.

Policy member Varma voted against his colleagues when it came to keeping the accommodative stance, arguing that the reverse repo rate was too low given the persistence of inflation. The RBI also revised up the inflation outlook by 60bps to 5.7% for the current fiscal year. In addition, a series of variable rate reverse repo (VRRR) auctions, which absorb excess liquidity in the banking system, were announced.  

However, at this stage policy normalisation is set to be very gradual for several reasons.

Firstly, policy measures to improve liquidity are still ongoing. The second round of the G-SAP programme has not yet finished and the TLTRO programme has already been extended to the end of the year. This is in line with recent remarks from both the central bank and the government, which sees the economic recovery continuing to be reliant on easy financial conditions. In his August statement, the RBI Governor Das implied that reducing liquidity quickly would let the economy “tumble”. And only a matter of weeks ago, the finance minister explicitly said that the economy was not ready for the RBI to drain liquidity.

The concern on the growth side ultimately surrounds the recovery in investment, which was slowing before the coronavirus crisis. Investment grew by only 6% in 2019, before contracting by 12.5% in 2020. But with asset quality issues and risk aversion hampering credit growth in the banking sector, investment is likely to need loose monetary policy for some time.

Not only this, the RBI are clearly under pressure from the government to keep interest rates low. Minutes from policy meetings show members explicitly discussing the potential of G-SAP having to continue until fiscal consolidation is adequate as higher rates make government borrowing more expensive.

Is the RBI behind the curve and what could it mean for financial markets?

Forecasting a dovish central bank is not easy. The RBI also expects inflation to remain above 5% through to the second quarter of 2022, with risks around their forecast fairly balanced. But given the ongoing policy measures and current communication, we expect the RBI to withdraw liquidity from early next year, hiking the reverse repo rate and tapering but continuing its G-SAP programme. The central bank should then look to raise the benchmark repo rate twice in the second half of next year.

But with already high inflation, there is clearly a risk that this is too slow given activity is recovering relatively quickly and real interest rates are still negative. There is also uncertainty forecasting capacity in the economy given supply bottlenecks and the long run fall in India’s potential growth rate. Household inflation expectations are also now rising, which, if sustained, could lead to even higher inflation.

For investors, this poses a risk the RBI tightens monetary policy too slowly, causing a tantrum in the bond market. Bond markets are still only pricing around three rate hikes in the next year, which, based on our inflation forecasts, would still leave real interest rates below zero. This is also a risk for equity investors, where sky high valuations present the main challenge to the Indian market but where the cyclical recovery and domestic flows are generally supportive.