The coming months will be a true test of ‘flexible‘ inflation targeting by the country’s central bank, according to foreign brokerage Nomura. The reason: Inflation shot up to a five-year high at 7.35% in December against 5.5% in November—way above the Reserve Bank of India’s (RBI) upper-bound target of 6% for inflation. This has raised concerns about the monetary policy committee’s ability to cut rates to support growth in the coming months.

To be sure, the surge in inflation was mainly driven by high vegetable prices and other food items that exaggerated the headline inflation print to a large degree. “Inflation is likely to remain elevated in January as well, but we expect supply-side pressures to ease after Q1 with headline inflation falling closer to 4.5-4.7% in Q2 and Q3, and sharply lower to ~2-2.5% in Q4. Hence, this surge is transitory,” notes Sonal Varma, economist at Nomura.

Food, oil, and gold, however, can create supply-side shocks to stoke inflation and weaken demand. In this situation, economists don’t expect a case of demand-pull inflation to contribute to a sustained rise in the general level of prices.

“We remain wary of the January print, which we believe will be similarly elevated, even though we expect vegetable price inflation to start contracting on a m-o-m [month-on-month] basis, reflecting a belated correction. While core inflation may inch up, we expect it to remain contained at around 4% in the poor growth environment,” Varma says.

Economists believe the stagflationary conditions will be temporary, since they expect supply-side pressures to ease and consumption shocks to reduce core inflation. “We expect the RBI to continue with the status quo at its next policy meeting in February, but should deliver another 25bp [basis point] rate cut by Q2. Meanwhile, we expect slippage on the government’s FY20 fiscal deficit target of 3.3% of GDP by ~0.4% of GDP, while attempting to consolidate it to 3.6% of GDP in FY21,” Varma says.

Nomura believes GDP growth has not bottomed out yet, and the inflation spike is transitory, while the growth downturn is more durable due to the triple balance sheet issue.

“The strategic retreat of monetary policy activism amid falling growth shifts the focus to the government’s policy guidance at its 1 February Union Budget. Lacklustre revenue growth (due to corporate tax cuts and disappointing disinvestment proceeds) will likely lead to a fiscal deficit slippage of at least 0.4% of GDP in FY20 (vs the target of 3.3% of GDP). We expect an elevated, albeit marginally smaller fiscal deficit of 3.6% of GDP in FY21 (vs the current target of 3.0%). Given the negative output gap, the fiscal impulse to growth will be negative in FY20 and neutral in FY21,” Varma says in the report.

India Inc. will closely watch every policy move of the central bank in the coming months with a clarion call for a rate cut to give growth a chance. However, the MPC is expected to stick to its mandate to contain inflation in the range of 4% with a margin of 2% on either side. The ball is now in the government's court to revive the animal spirits of the economy and bring the economy back on track.

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