“People who are worried about economic growth are typically quite articulate, that they have a platform to express their concerns, I have sympathy with that view (that growth is important)… But I just want to say that their voice is heard, but people who are hurt by inflation — the large majority of the poor — their voice is not heard.”
— Dr Duvvuri Subbarao, RBI Governor 2008-2013
The behaviour of central banks has undergone a sea change post Covid. While they have been extremely supportive of growth in response to the pandemic-related shock, they have also become tolerant of above-target “transitory” inflation, leading to a recalibration of their own inflation targeting framework in some cases. The emphasis of this narrative has deterred forward-looking financial markets from pricing in too much central bank action too early.
Repeated emphasis on inflation being transitory has led to a sort of Pavlovian conditioning of the bond markets. While the headline inflation continues to run comfortably above central bank targets, markets are no longer sure if and to what extent will the central banks react to the ongoing inflation dynamics. Bond markets, in other words, have become habituated to not making any inflation-driven yield curve adjustment without accompanying central bank guidance.
But as we move past Covid, we find little respite from the sharp build-up in inflationary pressures. Commodity prices remain elevated, shipping rates remain at record highs and even labour costs are gathering momentum. Hence, markets are again looking up to central banks for guidance. When will central banks signal the end of Covid era? How long can the inflation remain transitory before it is no longer transitory? Where is the fine line between normalisation and tightening? Which of the two, growth or inflation, will determine central banks’ reaction function going forward?
While the current macro-environment is putting pressure on RBI to scale down the size of the pandemic-led stimulus, the path to normalisation is expected to be very gradual and non-disruptive. RBI, therefore, has to navigate through the challenges of averting any market over-reaction to normalisation of the Covid-era accommodation.
In RBI’s forthcoming money policy, we therefore expect the MPC to keep the rates and its policy stance unchanged. We also expect RBI to communicate its intent to normalise banking system liquidity by providing a time and quantum-based guidance. While emphasizing the need for durable growth, RBI may acknowledge the stickiness of core inflation. In doing so, it may pass on the growth baton to the government, which has the fiscal wherewithal to address growth more directly at this juncture.
In summary, we expect RBI to signal the end of excessive accommodation of the pandemic and emphasize its intent to maintain what would still be an accommodative monetary policy.
(Churchil Bhatt is EVP for Debt Investments at Kotak Mahindra Life Insurance Company. Views are his own)