Reserve Bank of India (RBI) on May 4 Decided to increase the benchmark interest rate by 0.4 percentage points up to 4.4%. Over the past few months, there has been a growing demand to raise rates, compounded with concerns over retail inflation exceeding the central bank’s tolerance limit of 6% for three months. surprise for the markets was in RBI’s move, through an off-cycle meeting of the Monetary Policy Committee (MPC). In a discussion moderated by K Bharat Kumar, Shubhada Rao And ur bhati Discuss whether RBI delayed rate hike. Edited excerpt:
Should the RBI have acted on interest rates much earlier instead of waiting for retail inflation to reach 6%? After all its mandate is to target 4% inflation. The only tolerance limit is plus or minus 2%.
Shubhada Rao: It is important to understand the context in which most central banks have behaved over the past two years. It has been a tight cross between growth and inflation. We are passing through an ‘unusual’ phase that began with the onset of COVID-19, followed by the Russia-Ukraine conflict. Since March 2020, central banks have done everything they can to support growth on a global scale. As central bank balance sheets expanded, interest rates declined with a view to supporting growth through financial positions that were made ultra-easy. However, the concomitant side effect of COVID-19 was also a worldwide supply shock, which began to ease inflationary pressures. Commodity prices started rising, putting overall pressure on input costs. But at the same time, development was faltering. So, naturally, policy makers were leaning more towards supporting development. However, at some point, inflation began to bite.
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For example, in the US, the Fed was actually saying that inflation was transitory, while the markets believed that inflation had a more structural nature. Similarly, in India, we started seeing inflationary pressures, with the markets becoming more concerned about inflation. There was an expectation in the market that demand conditions would improve from the post COVID-19 years, which they did. The Purchasing Managers’ Index has started showing steady expansion in recent times for both manufacturing and services. Services have made a stronger comeback in view of the improvement in demand. Clearly, rising input costs were now beginning to manifest in pricing power back to manufacturers, and therefore, a pass-through to consumers was quicker than anticipated. The war in Europe and China’s strict lockdown affected supplies and logistics, and further disrupted supply chains. We have a perfect storm where growth has slowed, and inflation is rising dramatically.
Did RBI wait too long? maybe. February would have been a policy time when RBI could have voiced its concerns not only on the headline price index but also on core inflation as an economic monitor, which further reflects your underlying demand position.
What moved the needle was war. It is too early to hike rates last year as we were still grappling with growth problems. RBI had cushion till 6% of inflation, [which has been provided] For unusual circumstances like what we’ve seen in the last two years. As inflation has consistently threatened to remain above 6%, as per the mandate, it was imperative that the RBI’s focus be on containing inflation. Lower limit of rate shifted from reverse repo to fixed deposit facility. So, yeah, maybe February was the time when the commentary could have been safer and more [along] The markets seemed to suggest that we need to be cautious on inflation.
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UR Bhat: From an investment practitioner’s perspective, economics is not an exact science. So, you can’t really have a perfect model where if inflation goes above 6%, you immediately raise interest rates, because the 2-6% range is just one indicator. Also, the RBI’s own view on the causes of inflation has to be considered. It could wait to see if the war would stop or if oil prices would drop dramatically. Therefore, it cannot be seen as rushing to raise rates and, if something dramatic happens, to reduce them too soon. If the practice of monetary policy is as simple as building a model, an algorithm may work better than a central banker. It takes a lot of judgment and subjectivity. This is as good a time as any to raise rates.
But looking at it as a whole, I am not sure it was appropriate for the central bank to call an off-cycle meeting and hike interest rates; I don’t think nothing would have happened had I waited before raising this issue in the next MPC meeting. Quantitative easing or interest rate cycle normalization should always open systematically, as you need to give the market ample indication of what is to come. Markets are very good at interpreting data. Therefore, a central bank should always give some indication of what is really bothering them, what parameters are important to them to make a decision either way, so that the market can really consider it and can feed that information into prices. When there is a sudden change without any notice, there is turmoil in the market. That’s probably what happened last week.
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Also, are interest rate hikes really a great way to control inflation? If inflation is primarily due to supply chain problems, it has to be addressed. Also, the transmission mechanism is probably not that good; Because if you really look at the bank balance sheet, there are probably more than 75% of property loans. A lot of these are based on T-bills or external benchmark-related rates. Whether RBI hikes the repo rate or not, the market has already decided that interest rate hike is necessary, as that is how they are trading. All these notes related to the external benchmark were already being re-priced. Therefore, interest rates in the market are determined by market forces and not by fiat.
If the repo rate action has little effect, what else should the RBI do to rein in inflation?
Shubhada Rao: It is also important that the repo rate, which is usually an indicator rate, indicates that the underlying risks to inflation are real and are likely to be more durable. An increase in the interest rate is a necessary but not a sufficient condition. This has to come through in managing liquidity. By the end of April, we were already sitting on a surplus of ₹6.5 lakh crore. Raising the cash reserve ratio (CRR) by 50 points for banks will result in forfeiture of ₹87,000 crore from May 21. We believe that RBI is not going to stop with just one CRR hike. The combination of the benchmark rate as well as the liquidity available in the system sends the market a more comprehensive signal on upcoming tight financial conditions, which will help moderate demand. There will be sacrifices on production. We believe that there is a possibility of another hike in CRR, perhaps in the policy review in June. The surplus will come down to around Rs 2 lakh crore by the end of FY23.
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We are already witnessing coal shortage, which will have an impact on electricity rates; We are likely to see an impact on MSPs, which are calculated on the basis of input cost; India needs to keep a close watch on the crude basket. Given the global rise in food prices due to war, food costs are set to be steep even if we have enough food.
We, as a research entity, are forecasting inflation in the 6.1-6.3% band, hence around 6.2% average inflation for FY13, which is still higher than the revised inflation number of 5.7% presented by RBI in April is more. In the June policy, the RBI is likely to further amend it. So, there’s going to be a sacrifice very clearly on growth. But in the midst of inflation and growth, the RBI will certainly now lean towards inflation, as it is a very unequal tax on the less privileged.
What can the government do to make it easier? Reports say that the RBI is feeling isolated in its fight against inflation.
Shubhada Rao: What the government can do is perhaps further reduce the excise duty on fuel as far as possible, which will help ease the price pressure from headline fuel costs. Of course, the cost to the exchequer is significant, because even if there is a 5% difference in excise duty, it has an impact on the government balance sheet to the extent of ₹60,000-70,000 crore. Therefore, it has to be weighed very carefully. Also, the Center will have to make adjustments between revenue expenditure and capital expenditure. I think the finance minister had indicated that they were going to keep the pace of spending on infrastructure. And while we could see some growth relinquishing in FY13, the medium term, ie a few years ahead of FY13, may look better. The government through some of its policy initiatives during the COVID-19 years has done very well by placing significant emphasis on domestic manufacturing more actively in the form of production linked incentives for about 14-15 sectors. If not in FY23, we will see some of these supply constraints being eased from FY24 onwards.
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UR Bhat: Given that easing supply challenges can help quell inflation, the government will have to act. RBI can only use instruments like CRR, Statutory Liquidity Ratio, Repo etc. But dealing with supply side issues is out of its domain. Of course, no one can really decide which way the war will go or whether or not we will have a recurrence of the past with COVID-19. But as far as possible, where there are issues of transportation, container availability and the like, the government has to do its bit. It is also his duty to ensure that the pace of development does not waver. The government will have to continue spending until the private sector starts investing.
Having said that, the government is also trying to promote an environment of development. Heavy allocation was made for spending on infrastructure in the budget. This has a huge multiplier effect on the economy. Exports have also started showing emphasis. If you look at export growth and GST collection, we are doing very well.
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But the bigger concern is that we now have negative real interest rates for savers. This is probably due to the anemic increase in bank deposits. With negative real interest rates, savers will shift to the market, or to gold or real estate. I think more than two-thirds of the volume in the equity market is from retail investors. Apart from this, there is a risk of further depreciation of the rupee against the dollar. With the US Fed also raising rates, we will have to maintain the rate differential to help prevent dollar outflows.
Increase in repo rate and such instruments are effective only if you have high teens or credit growth of more than 20%. But as with 9-10%, the impact may not be that great in reducing benchmark rates.
How do you drive healthy credit growth?
UR Bhat: If we want GDP growth of 7% and if there is 6% inflation, it means 13% nominal GDP growth. It needs to be financed. Therefore, the banking system needs to be able to grow its credit book quite dramatically to be able to access these numbers. Due to the huge demand shock, private sector investment has retreated.
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As the economy slowly returns to normal, the private sector will start investing in new capacities. The biggest driver of new investment is the government’s investment in infrastructure. When you have good roads, port capacity, good railway capacity and good telecom, people will start investing and create demand in phases. These will happen. We have gone through such phase many times before. If you look at the GST collection and export numbers, things are not really that bad. we are getting there.
UR Bhat is the co-founder and director of Alphanity Fintech; Shubhada Rao is the founder of QuantEco Research