Will the Second Wave of COVID-19 and Inflation Turn the Interest Rate Cycle?

(Source: https://ourworldindata.org/ )

At this pace, only a third of India's population will be vaccinated by the end of 2021. We have a long way to go as regards the vaccination drive, and in between if new cases of COVID-19 rise; it may dent economic growth and inflict risk to the inflation trajectory due to supply-side disruption caused by COVID-19 restrictions or lockdowns.

The headline retail inflation reading for March 2021 came in at 5.52% -- close to the upper tolerance limit set by the Reserve Bank of India (RBI), whereas the core inflation, i.e. non-food-non-fuel inflation was at 6.07%. In FY21 the CPI inflation average reading was at 6.19%, higher than the RBI's upper tolerance limit. The ongoing stricter curbs on the economic activity have pushed the transportation cost of perishables higher.

As a result, the RBI is facing a big dilemma at present. On the one hand, the risk of inflation is mounting consistently, while on the other side it wants to keep rates low to sustain growth on a durable basis amidst the pandemic.

In the resolution of RBI's April 2021 bi-monthly monetary policy statement 2021-22, all six members of the MPC unanimously voted for keeping the policy repo rate unchanged, plus kept the stance of the policy accommodative as long as it is necessary to sustain growth on a durable basis and continue to mitigate the impact of COVID-19 on the economy while ensuring that inflation remains within the target range going forward.

However, now due to a massive surge in infections during the second wave, the growth dynamics have altered significantly. Although the RBI has reaffirmed a 10.5% GDP growth forecast for India during the first bi-monthly monetary policy of FY22, it is mainly due to a favourable base effect.

The RBI Governor, Mr Shaktikanta Das in the Minutes of the last monetary review meet states:

"Rapidly rising cases of COVID-19 is the single biggest challenge to ongoing recovery in the Indian economy. Learnings of last one year should, however, help us in managing the crisis as it unfolds."

As regards CPI inflation, according to Mr Das, mitigation of price pressures through timely supply-side measures on key food items and coordinated reduction in taxes on petroleum products by centre and states can help assuage cost pressures on inflation. But a combination of high international commodity prices and logistics costs may push up input price pressures across manufacturing and services, he observes.

RBI's Executive Director, Dr Mridul Saggar, a member of the MPC states:

"The economic recovery can come under risk if this new wave of infections is not flattened soon. This is especially so as monetary and fiscal policies have already used most of their space to considerably limit the loss of economic capital, though expansion of policy toolkits can still afford additional comfort. While the countrywide dispensation is still quite supportive of production activity, this can change if the virus spread, hitherto contained to few States, might transmit across the country. Learning effects on calibrating stringency of restrictions may keep economic costs of the second wave much lower than the first but still retard full normalisation by a quarter or two. Ramping up vaccination, testing and treatment holds the key to protecting economic recovery and health policies have become the first line of defence. Monetary and fiscal policies can only play a second fiddle."

As regards CPI inflation, Dr Saggar is of the view that the momentum pressures for CPI may exacerbate in the near term if producers so far absorbing a large part of cost-push pressures decide to pass through the price pressures to the retail level. Global commodity prices may also affect inflation in his view.

Notwithstanding the above, certain external members of the RBI's MPC have expressed more concerns...

Prof. Jayanth Varma of the Indian Institute of Management, Ahmedabad, who voted in favour of keeping policy repo unchanged at 4.00% and continue accommodative policy stance, articulated:

"The economic recovery after the pandemic shock of 2020 remains uneven and incomplete, and the renewed jump in COVID-19 infections in certain parts of the country has increased the downside risk to the growth momentum. On the other hand, inflation rates have been consistently well above the mid-point of the target zone and is forecast to remain elevated for some time. This is a difficult situation."

Raising questions on the forward guidance Prof. Varma said:

"From my perspective, the principal motivation for the forward guidance was to reduce long term yields in the backdrop of an excessively steep yield curve. Unfortunately, forward guidance has failed to flatten the yield curve, and I see little merit in persisting with it anymore."

He also highlighted the limitations of monitory policy in flattening the yield curve through the available policy tools. Furthermore, he believes it will imprudent to repose excessive faith in forecasts, and instead, the MPC must have the agility and flexibility to respond rapidly and adequately to whatever surprises new data may bring in the future.

Another external member, Dr Ashima Goyal, Professor, Indira Gandhi Institute of Development Research, Mumbai, observed growth uncertainty has increased with the second wave in COVID-19 in some states. On India's prospective GDP growth she said:

"Even the above ten per cent growth most analysts still expect for 2021-22, however, will barely take us to the level we had reached in 2019. We have to also make up for lost time; alleviate widespread job loss and income stress. Expected growth is high because of the base effect and does not imply sustained growth at potential. Only when we reach the latter will true recovery have taken place."

Dr Goyal expects headline inflation to remain well within the MPC's tolerance band over this year, but observes that core CPI inflation is rising.

Dr Shashanka Bhide, Senior Advisor, National Council of Applied Economic Research, Delhi also stated:

"The pace of recovery of output needed to offset the negative impact of the Covid 19 shock to the economy in terms of growth in income and employment will be substantial and sustained over many years. Going forward, success of vaccinations, universal adoption of preventive measures to severely limit the chances of transmission of the virus and investment in health services to assure access to health care will define the course of economic recovery. "

As regards CPI inflation, the 'fuel and light' category and particularly the core inflation, inflict risk to the inflation trajectory, plus is subject to the type of south-west monsoon and the pattern of recovery of the domestic economy.

The international credit rating agency, S&P Global Ratings, has already sent signals that the second wave of the COVID-19 pandemic poses a downside risk to India's economic growth and may impede its recovery. "This (the second wave of COVID-19 pandemic) may prompt us to revise our base-case assumption of 11 per cent growth over fiscal 2021-2022, particularly if the government is forced to reimpose broad containment measures," S&P said in a statement.

India Ratings and Research (Ind-Ra), a 100% owned subsidiary of the Fitch Group (a global leader in financial information services with operations in more than 30 countries), has already slashed India's growth forecast for FY22 by 30 basis point (bps) from 10.4% to 10.1% citing the massive second-wave and slow vaccination as the primary reasons.

Data as of March 2021
(source: MOSPI, RBI, PersonalFN Research)

If you think, RBI may not undertake policy tightening so early, especially given the dire consequences of the second wave; you should look at other emerging markets for reference.

Experience in the other emerging markets is no different. Recently, The Central Bank of Russia raised the key rates by 50 basis points (bps) -- from 4.5% to 5.0%. In Russia, not only the consumer prices are rising but inflation expectations have been high as well. Russia has witnessed a steady recovery from the pandemic.

Brazil, another country badly affected by COVID-19, has signalled aggressive monetary tightening. In March, the Central Bank of Brazil hiked the key rates for the first time in the last six years. Owing to the ultra-loose monetary policy measures adopted until recently, the rate normalization in Brazil is expected to happen quicker than expected earlier. In Brazil, rising inflation has been one of the most crucial policy considerations.

(Image source: freepik.com; photo created by d3images)

It's noteworthy that RBI has retained its target inflation range of 2%-6% for the next five years. This underscores the role of inflation targeting in maintaining the macro-economic stability and credibility of the framework.

Going forward, if retail inflation reports a higher reading that is beyond RBI's comfort range, the six-member MPC would be left with no option but to increase policy rates. The RBI, however, would ensure that liquidity conditions in the system remain comfortable.

The government is expected to borrow Rs 1 lakh crore every month in FY22. If RBI decides to raise policy rates, the government would be at a big loss. Besides, businesses and retail borrowers would be affected as well since borrowing cost will move up.

On the other hand, the retirees and those who largely depend on the interest income would get some relief as interest rates on bank deposit rates and Small Saving Schemes may increase. At present, the real returns (also known as inflation-adjusted returns) earned on bank fixed deposits and Small Saving Schemes is barely anything, and in some cases even negative.

What strategy should the debt fund investors adopt?

Overall it appears that the present interest rate cycle has bottomed out. Most of the rally at the longer end of the yield curve has already come about since the time RBI started reducing policy rates. Debt securities with longer maturity papers may not be able to generate attractive returns as seen in the last couple of years. In the current uncertain times, the longer end of the yield curve could be more sensitive than the shorter end. The returns may moderate on the longer end of the yield curve and could turn riskier (may encounter high volatility) in the foreseeable future.

To approach debt mutual funds, now the shorter end of the yield curve looks more attractive. You'll be better off deploying your hard-earned money in shorter duration debt mutual funds. But approach even short-term debt funds with your eyes wide open--pay attention to the portfolio characteristics and quality of the scheme. Stay away from debt mutual fund schemes that have exposure to low-rated securities in the hunt for yield amidst a time when the credit risk has intensified.

Stick to debt mutual funds where the fund manager does not chase yields by taking higher credit risk but instead focuses on government and quasi-government securities.

As far as possible, avoid Credit Risk Funds as they are likely to be more vulnerable amidst the financial crisis followed by the COVID-19 pandemic. Remember, investing in debt funds, in general, is not risk-free.

At present, you would do better going with only pure Liquid Funds and/or Overnight Funds that do not have exposure to private issuers.

Finally, I would only say, do not take RBI's accommodative stance for granted and avoid taking unwarranted risks with your debt fund portfolio.

Assess your risk appetite and investment time horizon while investing in debt funds. And prefer the safety of principal over returns. Alternatively, if you prefer to keep your capital safe, opt for bank fixed deposits, but choose the bank carefully; the interest rates on deposits may rise in time to come.

Happy Investing!

Warm Regards,
Rounaq Neroy
Editor, Daily Wealth Letter

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