NEW DELHI: The Reserve Bank of India on Friday raised the key policy rates by 50 basis points (bps), bringing the repo rate to 5.40%, 25 bps above the pre-pandemic level of 5.15% in February 2020.
The repo rate is now up from a 20-year low of 4% to 5.40% all in a matter of few months as the central bank looks to mitigate inflation.
This was the second consecutive hike of 50 bps, and the third rate hike of this fiscal. The monetary tightening was triggered by high inflation, synchronised policy tightening globally, and volatile global financial conditions.
“The frontloading of the repo rate hike was needed as inflation, despite some softening, is still way above the upper tolerance limit. It also partly addresses the spillover risks from sharper rate hikes by the US Federal Reserve (Fed) and other major central banks. In this backdrop, we expect the RBI to raise the rate by another 25 bps in its September monetary policy meeting. The future pace of hikes will depend on incoming data,” said Dharmakirti Joshi, Chief Economist, CRISIL.
Why the aggressive stance?
Elevated inflation:
Being an inflation-targeting central bank, the RBI is worried about headline inflation staying above target for the past two quarters, said Joshi.
Even as CPI inflation came off its peak of 7.8% in April to 7.0% in June, it was a full percentage point above the RBI’s upper tolerance limit. The MPC expects CPI inflation to remain above 6% in the next two quarters as well. It projects a gradual moderation from 7.3% in the first quarter (Q1) to 7.1% in Q2, 6.4% in Q3 and 5.8% in Q4 of fiscal 2023, reaching 5.0% in Q1 next year.
Inflation is expected to remain higher than the RBI’s medium-term target of 4% even in Q1 of fiscal 2024.
A stubbornly high inflation can trigger second-round effects.
Commodity prices may have eased but are still higher than last year
Despite the recent softening in international commodity prices, these remain volatile and higher than last year.The RBI inflation forecast assumes Brent crude price to average $105 per barrel this fiscal, compared with $80 per barrel last year. While the RBI’s survey of firms in manufacturing and service sectors indicates softening of cost pressure in the second half (H2) of this fiscal, they are increasing the passthrough of these costs to consumers.
IIM Ahmedabad’s Business Inflation Expectation Survey for June shows that despite persistence of high cost pressure, business inflation expectations are moderating. Core inflation, even after accounting for relief on petrol and diesel prices, remains elevated and broad-based. For some food prices, rising kharif sowing might offer relief, but critical crops such as rice, where sowing is lagging, will be monitored.
“High costs will maintain a broad-based pressure on retail prices. The intensity and distribution of monsoon will also need to be monitored, especially as food supplies are tight. A well-distributed monsoon can help ease inflation in the second half,” said Crisil in a note.
Aggressive monetary tightening globally:
The RBI is worried about the spillover effects of synchronised monetary policy tightening globally, especially as the Fed is hiking at a faster pace. “Compared with 140 bps hike by the RBI, the Fed has hiked its policy rate by 225 bps in 2022 so far. The governor views global financial conditions as tense, despite intermittent relief. Sharp appreciation of the US dollar is putting pressure on the rupee even as domestic fundamentals remain resilient. A weakening rupee can further add to domestic inflationary pressures through higher cost of imports. The RBI’s tight monetary policy will also help cap capital outflows amid volatile global financial conditions, and control the rupee’s depreciation,” said Doshi.
Reduce pressure on the rupee: The RBI’s policy tightening is also expected to reduce pressure on the rupee from widening the current account deficit (CAD), while aggressive monetary policy tightening by major advanced economies could impart volatility to capital inflows.
“The depreciation pressures on rupee are mounting from the continued net FII outflows and there are concerns about widening current account deficit. However, the increase in repo rate hike is likely to be smaller as growth is expected to moderate sharply,” said Dr. Arun Singh, Global Chief Economist, Dun & Bradstreet.
Impact on the banking and financial services sector
With an increase of 140 bps in the repo rate so far this fiscal, and an additional front-loaded increase in next policy, the cost of deposit for banks is expected to increase 25-30 bps vis-à-vis an increase in loan yield of 80-90 bps, noted rating agency Crisil in a note.
The RBI’s actions and robust credit growth have crunched liquidity to Rs 1.05 trillion as on July 31 from Rs 1.81 trillion mid-July and Rs 2.26 trillion at the start of the month.
Bank credit increased 13% on-year, way ahead of deposit growth of 8.4% on-year as on July 15, because of faster growth in retail credit and recovery in wholesale segments as evident by increase in capacity utilisation in the manufacturing sector to 75.3% in the last quarter of fiscal 2022 vs the long-term average of 73.7%. With continued growth momentum in retail and agriculture segments, supported by recovery in services and industrial credit, Crisil Research expects bank credit to grow 10-12% during fiscal 2023.
What about growth?
On the growth front, the RBI retained its FY2023 forecast at 7.2%, highlighting improving agricultural prospects benefiting rural consumption, increasing demand for contact-intensive services and improving business and consumer sentiment aiding urban consumption, and government’s capex push, improving bank credit, and rising capacity utilization supporting investments. However, the RBI also noted downside risks emanating from persisting geopolitical tensions and increased global financial market volatility and tightening global financial conditions.
“While we expect the MPC to continue with rate hikes as a line of defense for rupee stability and elevated inflation, the need for aggressive rate hikes has reduced amid global disinflationary pressures and assessment of monetary tightening on growth-inflation dynamics. We expect the CPI inflation trajectory to be lower than the RBI’s estimates by 70 bps in 1HCY23. We, thus, expect the repo rate at 5.75-6% by end-CY2022,” said Upasna Bhardwaj, economist at Kotak.
What are the other positves?
RBI’s commentary indicates that despite global headwinds the economic activity in India has remained resilient and even going forward may benefit from the ongoing south-west monsoon rainfall which at the aggregate level is 6% above the long period average (LPA) as per the latest data.
The other positives include softening of edible oil, pulses and eggs prices, strengthening of urban demand, gradual improvement in rural demand, holding up of exports demand, government’s capex push, and healthy growth in bank credit, said Dr. Sunil Kumar Sinha, Principal Economist, India Ratings and Research.
India Ratings and Research believes the current policy rate hike cycle is expected to continue till RBI reaches what is known as “neutral policy rate”. This is the short term policy rate which is expected to stabilize the economy down the road in the long run. “In other words, this is the rate which is expected to let the economy realize its growth potential but keep the inflation within the target range and inflationary expectation well anchored. In Ind-Ra’s view under the current macro environment this neutral policy rate may be in the range of 6.0% – 6.5%. However, future rate hikes besides guided by the evolving geopolitical situation would also be data dependent,” said Sinha.