The RBI’s Monetary Policy Committee raised the benchmark interest rate for a third straight meeting as policymakers battle to rein in inflation.
Why were the benchmark interest rates raised?
The 50 basis points raise takes the policy repo rate to 5.4%, and, more significantly, to a level last seen in the pre-pandemic second quarter of fiscal 2019-20.
This is when a growth slowdown and retail inflation of about 3.2% warranted a rate cut.
The rate-setting panel had little option but to continue the withdrawal of monetary accommodation to prevent inflation.
The prices of some of the industrial commodities and food items softened in recent weeks.
The policymakers clearly opted to stay strongly vigilant at this juncture and erred on the side of caution, if needed.
The RBI regards growth recovery based on a set of indicators, such as industrial capacity utilization, credit growth, government Capex and PMIs.
The central bank kept its 2022-23 growth forecast of 7.2 percent unchanged.
From an external sector and exchange rate perspective, globalized inflationary surges are prompting policy tightening in advanced economies.
This is in turn roiling currency markets including appreciably weakening the rupee and adding imported inflation to the mix.
Russia’s invasion of Ukraine and the resultant impact on trade flows from the conflict zone have upended supply chains for several commodities and added to price pressures for a range of goods.
The latest geopolitical tensions were triggered in East Asia by U.S. House Speaker Nancy Pelosi’s visit to Taiwan in the face of Beijing’s dire warnings.
And China’s decision to respond with aggressive military drills around one of the world’s busiest shipping lanes could also impact global trade.
All these are at a time when uncertainty and risk aversion are already high.
Why have there been rapid hikes?
Successive shocks to the global economy had led multilateral institutions including the IMF to lower their global growth projections and highlight the rising risks of a recession.
With all the six members in favor of a 50 bps hike, the MPC has delivered a 140 bps hike in the repo rate in less than three months, by far the fastest pace of rate hikes in recent years.
Meanwhile, the liquidity surplus in the banking system also continued to move lower.
Interestingly, one of the MPC members did not support the monetary policy stance of “withdrawal of accommodation” and perhaps preferred a more cautious stance.
The RBI announcement clearly prompted the fixed income markets to expect more rate hikes ahead.
This leads to the 10-year benchmark bond yield to climb higher to around 7.30 percent, about 20 bps higher than the intra-day low observed prior to the MPC communication.
Even if the current approach means a somewhat slower recovery immediately, the central bank stays focused on financial stability and long-term sustainability of growth.
In the context of deciding on the terminal policy rate, a factor will likely be the share of assets books of the banking system that reflects external benchmark linked rates (EBLRs).
At over 40 percent now as against a tiny single-digit number in the previous hiking cycles, which is witnessing nearly instantaneous and complete pass-through of the central bank’s rate signals.
What is the deficit problem?
The unusually large trade deficit in recent months, FII outflows during the summer, and potentially a sizeable deficit on both current and capital accounts have led to this move of the RBI.
The rupee also touched the psychological mark of 80 against the dollar recently, one sees this as a result of generalized dollar strengthening despite the rupee outperforming a large number of other currencies.
Also, India’s trade gap will likely narrow in H2 of 2022-23.
Furthermore, the RBI is not only using a part of its sizeable forex portfolio to support the rupee, several other policy initiatives on the part of both the RBI and the government.
For example measured trade restrictions, rupee settlement in external trade, and greater flexibility for banks as regards non-resident deposits.
All these should help materially in the coming months in containing rupee weakness.
This would help anchor price gain expectations firmly and surely enhance the RBI’s inflation-fighting credentials.
What is the way forward?
Disquietingly, globalization of inflation is coinciding with deglobalization of trade.
The MPC has clearly chosen to stay cautious, a broad stance that will likely continue in the late September MPC meeting also.
However, incoming data on the evolving growth-inflation dynamics both at home and abroad, and external sector situations will play a key role in determining the MPC’s bias subsequently.
Barring further unforeseen surprises, a relatively less challenging backdrop as regards these parameters may allow the MPC to keep the repo rate unchanged during H2 FY23.
