RBI MPC deploys a bazooka in order to tame inflation
Premium- Rate changes are likely to have significant implications for lending and market rates
Reserve Bank of India (RBI) deputy governor and Monetary Policy Committee (MPC) member Michael Patra’s comments in the minutes of the April 2022 policy review turned out to be prophetic: “The view that increasingly occupies centre-stage is that irrespective of whether supply bottlenecks are the driver or pent-up demand, it will become more difficult to tame inflation the longer the fight is delayed."
The MPC certainly delivered a surprise. In an off-cycle meeting, MPC members voted unanimously to increase the policy repo rate by an unconventional 40 basis points (bps)—one basis point is one hundredth of 1%—with immediate effect; that takes the repo rate up to 4.4%. This formally starts the rate hike cycle. Given the rate corridor structure of monetary policy that was changed in the April policy review, the Standing Deposit Facility (SDF) rate will also rise from 3.75% to 4.15%. We believe this front-loading to be the right decision.
In addition, RBI also hiked the Cash Reserve Ratio (CRR) for banks by 50 bps from the earlier 4% of deposits (technically, Net Deposit and Time Liabilities (NDTL) to 4.5%. Recall, that RBI had cut the CRR from 4% during the earlier off-cycle review in March 2020 (after the pandemic-induced lockdown) to 3%, and then reversed it in two phases in April and June 2021. The changes in the repo rate and the CRR are likely to have significant implications for lending and market rates.
What might have been the proximate causes for the pre-emptive action? Based on data available publicly, not much has changed in macroeconomic and financial market conditions since the April 2022 review. In the external arena, markets and analysts had anticipated and priced in many G-10 central banks, particularly the US Federal Reserve, being more aggressive in their tightening cycles, including front-loading the rate hikes. As we write this, the US Federal Open Market Committee (FOMC) is likely to hike the Fed Funds Rate target by 50-75 bps.
One data point which indeed was a surprise post the 8 April MPC review was the March Consumer Price Index (CPI) inflation print of 6.95%, significantly higher than the median street forecast of 6.35%. Although this was largely driven by higher-than-expected food prices, this will shift the entire inflation trajectory upwards. While there is no revision of FY23 CPI inflation forecast in this review (from the 5.7% average expected in April), actual inflation is likely to average 6.5%+. Note that this is premised on crude oil averaging $100 a barrel (as well as other metals, food prices remaining elevated).
One implication of this expected upward shift in the inflation trajectory is that the MPC is likely to face at least three consecutive quarters of CPI inflation remaining above 6%: The Q4 FY22 average inflation was 6.34%, and Q1 and Q2 FY23 are also very likely to have 6%+ prints. If this actually does materialize, the MPC is mandated to write to Parliament explaining the reasons.
Despite swings in food and fuel prices, the fact that “core" CPI inflation has persistently remained above 5% since June 2020 suggests that there is a demand component augmenting the series of supply shocks; core inflation simply cannot remain this elevated for such a long time. The RBI governor’s statement supports this: “… persisting high growth in non-oil, non-gold imports reflects a durable revival in domestic demand." Moderating this revival will be crucial to taming inflation.
Any central bank’s biggest concern is inflation getting embedded into household and business expectations, leading to debilitating wage negotiations in tightening labour markets. While the March RBI household survey showed a still very limited rise in three-month expectations, the salience of the recently reported acceleration of input cost pass throughs into end-consumer prices across multiple segments is likely to begin to shift these expectations upwards. Combine this with already tight labour markets in some tech-oriented sectors and the evidence of a closing “output gap", and the concern becomes real.
What now, going forward? The MPC will look to raise the real repo rate up to 0% or above, closing the gap between the nominal repo rate and expected inflation, probably in FY23 itself, or in early FY24. Although inflation is likely to remain a problem at least for some months, we believe the MPC and RBI will not raise the repo rate in a pre-set path; the tightening will be driven by data and evidence. There is too much uncertainty pervading the future outlook. As it is, rate tightening by G-10 central banks will force a global growth and trade slowdown, already forecast by the International Monetary Fund, World Bank, and the World Trade Organisation. Steep domestic tightening may slow growth momentum beyond levels consistent with taming inflation.
The author is executive vice-president and chief economist at Axis Bank. Views are personal.