Hawkish tone led by inflation concerns, further rate action expected

The Reserve Bank of India’s monetary policy committee (MPC) on December 7 raised policy rates by 35 basis points (bps), taking the repo rate to 6.25 percent, as was widely expected by the market.

What surprised the market was that the MPC adopted a hawkish tone in the policy, at a time when inflation expectations have started to come off, globally as well as in India.

The takeaways from this policy are: (a) the RBI is not too worried on the growth front, despite the expected global slowdown (b) it is quite concerned about the elevated inflation, especially the persistent core inflation and (c) the policy stance continues to be “withdrawal of accommodation”.

The RBI moderated its real GDP forecasts for FY23 by 20 bps to 6.8 percent, led largely by a drop in Q4. The outlook for the first two quarters of FY24 is a bit mixed, with 7.1 percent for Q1 and 5.9 percent for Q2.

Despite the widely expected global slowdown (an outcome of the aggressive tightening), the RBI is still quite optimistic about domestic growth and expects the Indian economy to be resilient and the fastest growing among major economies.

The optimism is built around increasing investment activity led by government expenditure, improving consumer confidence, recovering rural demand, improving business outlook as well as expected expansion in the services sector. The risks will continue to flow from the evolving global macro and geo-political situation.

On the inflation front, the RBI has kept its forecasts largely unchanged. In fact, it has tweaked the quarterly forecasts slightly upwards.

The central bank expects the headline CPI to moderate from the current levels to 5 percent in Q1FY24 but again rise to 5.4 percent in Q2FY24.

While moderating food inflation is expected to bring down the CPI trajectory, the RBI finds the core inflation sticky and elevated.

Inflation war

A noticeable shift in the policy stance was the reference to the sticky core CPI and the resolve to “break the core inflation persistence”.

Further, as we expected, the RBI governor emphasised the objective of the MPC to not only bring the headline CPI below the 6 percent upper end of its 2-6 percent tolerance band but also closer to the median level of 4 percent.

In fact, the expressions used by Governor Shaktikanta Das during his speech – “the battle against inflation is not over” and “we will keep Arjuna’s eye on the evolving inflation dynamics” – suggest that further policy action can be expected from the MPC.

The system liquidity continues to be surplus and the RBI expects the liquidity conditions to improve further due to multiple factors.

The central bank will continue to be in “liquidity absorption mode”, while being nimble and flexible in its liquidity management, and injecting liquidity as and when required.

Overall, the policy tone is hawkish, given the clearly stated focus on bringing down core inflation as well as bringing CPI inflation closer to the 4 percent target, along with the continued stance of “withdrawal of accommodation”.

Also read: Another rate hike on the cards in February?

Another hike coming?

A 25 bps repo rate hike in the February 2023 monetary policy is now pretty much on the cards. As in the 30 September policy, Das did not provide any guidance around the expected terminal repo rate but 6.5 percent is now looking very realistic, with slight risk on the upside.

The key ponderables will mainly emanate from the evolving global inflation and interest rate scenarios and the behaviour of the US dollar.

Global economists are widely expecting inflation to have peaked in the US and Fed rate hikes to therefore come to a halt soon, accompanied by weakness in the dollar.

In this base case scenario, the RBI could very well pause at a 6.5 percent repo rate but if any of these assumptions get challenged next year, the central bank might just want to elongate the rate cycle a bit more.