As expected, the members of the monetary policy committee voted to raise the repo rate by 50 basis points at 5.9 percent. One member voted for a more moderate increase of 35 basis points. The policy stance continues to be (as at the August meeting) “focused on withdrawing accommodation”, indicating the continued primacy of inflation moderation (price stability) and thus further rate hikes.
The average CPI inflation forecast was retained at 6.7% for 2022-23, with balanced risks (rising rice and pulses and falling oil and metal prices). However, the GDP growth forecast fell to 7% (from the previous estimate of 7.2%) after a slightly weaker than expected first quarter of 13.5%.
Monetary policy is now entering a phase that will require a coordinated approach to interest rate, liquidity, and exchange rate responses, as RBI decision-making will operate within the “impossible trinity of macroeconomics.” open economy” – that is, the inability to independently determine national interest rates when the exchange rate is market-determined and the capital account is open.
India’s external “financial conditions” are expected to remain tight for the foreseeable future. The US Federal Reserve will continue to raise its policy rate in a methodical manner to keep inflation under control, as strong aggregate demand is bolstered by a tight labor market. The current view on the magnitude of further Fed rate hikes is likely underestimated, as monetary policy transmission in the US is relatively weak – it has a large stock of broadly priced home loans at long-term fixed interest rates and therefore relatively insensitive to policy rate changes. Therefore, it is reasonable to assume that the dollar will remain strong in the near future.
Europe, on the other hand, must resort to various fiscal and administrative measures to mitigate the impact of soaring energy prices on household consumption. Some central banks reacted by warning against more aggressive tightening to offset these expansionary fiscal measures. In addition, slowing Chinese growth—due to various structural weaknesses and policy restrictions—is translating into currency depreciation, which is also likely to impact exchange rates in other Asian emerging markets.
What does this imply for monetary policy in India? First, MPC actions will always be determined by domestic inflation, growth and broader financial conditions. However, the second-order effects of global policy spillovers and the expected broader economic downturn are sure to influence domestic conditions through financial, commodity and trade channels.
India’s aggregate demand (hence the growth momentum) remains surprisingly resilient, even after cumulative repo rate hikes of 140bps since early May (excluding this hike). Direct tax collections remain high, indicating, among other things, the strength of corporate finances. GST collections (along with e-transportation billing trends) suggest strong economic activity. The Purchasing Managers’ Indices (PMI) for industry and services show solid order books. Manufacturing capacity utilization hit its highest level in three years in the first quarter of this year, evidence of a narrowing “output gap”. In addition, non-oil and gold imports also remain robust.
At the same time, CPI inflation is expected to remain high in 2022-23, although it peaks in September. Although this will largely be the result of food prices, even core inflation is expected to remain persistently high, averaging 5.9% in the second half of the year. Household inflation expectations had so far remained reasonably anchored, but the three-month outlook rose by 50 basis points in the RBI’s September survey. Inflation expectations are very important for central bankers, as any unanchoring after persistent high price shocks is likely to spill over into wage negotiations. In India, there are signs of increased demand for labor in certain skill segments, and larger wage increases could amplify aggregate demand and price pressures.
Based on, among other things, this growth and inflation scenario, we still expect the maximum (“terminal”) repo rate in this tightening cycle to be around 6.5%, based on real (inflation-adjusted) “natural rates” suggested by RBI analysis and a one-year inflation forecast of 5% (given that monetary policy is calibrated over a one-year horizon ). RBI remains reluctant, and with good reason, to provide forward-looking guidance on this matter, given the “highly uncertain” and rapidly changing global market conditions. But it is reasonable to expect that repo rate hikes will now be more calibrated to changing inflation and growth dynamics, rather than the rate actions widely anticipated since May. .
Along with rate actions, the system’s liquidity management will be essential to guide short-term money market interest rates, which determine the cost of funds for financial intermediaries, and therefore (the benchmark non-repo) lending rates. RBI has used liquidity measures to guide these short-term rates higher since October last year with a firm hand, implementing de facto “accommodation removal” well before the official tightening began. It started with the narrowing of the lower bound of the policy rate corridor in April, before starting with the increases in repo rates in early May. As a result, the actual tightening was greater, with market interest rates rising much more than the 190 basis point increase in the repo rate. This reduces the financial risks associated with the narrowing of the spread between the key rate and the Fed rate.
Still, the expected narrowing of the spread with US interest rates is one of the reasons why the rupiah is likely to remain volatile for some time. The art of monetary policy is to use specific instruments to target several objectives in order to achieve the desired results at minimum economic cost. Although an interest rate defense is a classic response to a depreciating currency, it is too broad an instrument. The RBI (in coordination with the government) has an extensive set of measures to modulate foreign exchange flows – these are likely to be rolled out gradually. As in the past, the skillful use of policy choices can be expected to minimize the “growth sacrifice ratio” while guiding inflation to a gradual decline over the next two years towards the target of 4%.
The author is Executive Vice President and Chief Economist, Axis Bank. Views are personal