Is RBI too optimistic about India’s growth?

The increase was widely expected as it came as the US Federal Reserve raised its key short-term interest rate, the federal funds rate, by 75 basis points to 3-3.25% in September. Given that the US Fed drives the direction of global monetary policy, it makes no sense for another central bank to fight the Fed. RBI is no exception to this.

Besides, interest rates in the Indian economy are rising anyway.

The RBI is trying to protect the value of the rupee by selling dollars and buying rupees from its reserves. Until recently, there was a lot of money floating around in the financial system, which was of no use to the banks. So, when RBI sold dollars, it took out this excess liquidity. This and increased lending by banks (as we shall see) have ensured that the excess liquidity is now more or less exhausted.

In addition, lending by banks has accelerated. As of September 9, year-on-year non-food credit growth stood at 16.7 per cent, the fastest growth since September 2013.

In comparison, as on September 9, the year-on-year growth in deposits was 9.5%, indicating a wide gap between credit growth and deposit growth. This gap and the end of excess liquidity in the financial system is driving up interest rates. The demand for money has increased. There is no supply.

It is expected that this increase in interest rates will help to rein in inflation, at least the consumer-demand-driven part. RBI’s retail inflation forecast for FY23 remains unchanged at 6.7%. The upper tolerance level for inflation is 6% as per RBI’s agreement with the government.

If retail inflation remains above 6% for three consecutive quarters, the RBI is considered to have failed to meet the inflation target. As stated in the latest Monetary Policy Statement: “Inflation is likely to remain above the upper tolerance level of 6% during the first three quarters of 2022-23.” This means the RBI is likely to fail to fulfill its mandate this year.

What makes the situation worse is that core inflation (after excluding food and fuel items) remains high. It was up a little over 6% in August. As stated in the monetary policy statement: “Basic … inflation remains high with upward pressure across various constituent goods and services.” This means that inflation is not being driven solely by higher food and fuel prices; And this is to become systemic.

At the same time, the situation in Ukraine is not likely to ease as the war continues. In addition, the Fed and other rich-world central banks are trying to combat decadal-high inflation by raising interest rates, which could lead to an economic slowdown or a massive recession in the rich world.

As US Federal Reserve Chairman Jerome Powell said recently: “I think there is a very high probability that we will have a period … [of] Too little growth.” More and more economists are predicting a recession in Europe as well.

This is definitely going to affect the economic growth in India by dragging down the growth in exports, for one. Taking these factors into account, RBI reduced the economic growth forecast for FY23 to 7%. It had earlier forecast a growth of 7.2%. Globally, the way things are right now, it may turn out that the RBI is being more optimistic than it should be. Optimism could be seen in Governor Shaktikanta Das’s address, which ended with the following statement: “Today, despite clouds gathering over the global economy, the Indian economy inspires optimism and confidence.”