Reserve Bank of India’s (RBI) deputy governor and Monetary Policy Committee (MPC) member Michael Patra’s remarks in the minutes of the April 2022 policy review proved prophetic: “The idea that centrally is increasingly pervasive, regardless of supply regardless of. The bottlenecks are the drivers or suppressed demand, the longer the fight is delayed, the more difficult it will be to contain inflation.”
MPC certainly delivered a surprise. In an off-cycle meeting, MPC members voted unanimously to raise the policy repo rate by an unconventional 40 basis points (bps) – a basis point being one-hundredth of 1% – with immediate effect; Which takes the repo rate down to 4.4%. This formally starts the rate hike cycle. In view of the changed monetary policy rate corridor structure in the April policy review, the Fixed Deposit Facility (SDF) rate will also increase from 3.75% to 4.15%. We believe this front-loading is the right decision.
In addition, the RBI raised the Cash Reserve Ratio (CRR) for banks by 50 bps to 4.5% from the earlier 4% of deposits (technically, Net Deposit and Time Liabilities (NDTL)). Remember, that RBI reduced the CRR from 4. 3% during an earlier off-cycle review in March 2020 (after the pandemic-induced lockdown), and then reversed it in two phases in April and June 2021. Changes in the repo rate and CRR are likely to have significant implications for lending and market rates.
What could be the proximate reasons for the pre-emptive action? Macroeconomic and financial market conditions have not changed much since the April 2022 review, based on publicly available data. In the external sector, markets and analysts had forecast and priced several G-10 central banks, notably the US Federal Reserve, to be more aggressive in their tight cycles including rate hikes. As we write this, the US Federal Open Market Committee (FOMC) may raise the fed funds rate target by 50-75 bps.
One data point that was really surprising after the MPC review of April 8 was the March consumer price index (CPI) inflation print of 6.95%, which was significantly higher than the average street forecast of 6.35%. Although this was primarily driven by higher-than-expected food prices, it would shift the entire inflation trajectory upwards. While there is no revision in the CPI inflation forecast for FY13 in this review (from the estimated 5.7% average in April), real inflation is expected to average 6.5%+. Note that this is based on an average of $100 per barrel of crude oil (plus other metals, rising food prices).
One implication of this expected upward change in the inflation trajectory is that the MPC may face at least three consecutive quarters of remaining CPI inflation above 6%: Q4 FY22 average inflation was 6.34%, and Q1 and Q2 FY23 also very likely to print 6%+. If it is actually implemented, then it is mandatory for the MPC to write a letter to the Parliament stating the reasons.
The fact that “core” CPI inflation has remained consistently above 5% since June 2020, despite volatility in food and fuel prices, suggests that there is a demand component driving the chain of supply shocks; Core inflation simply can’t stay that high for such a long time. The RBI governor’s statement backs it up: “…the consistently high growth in non-oil, non-gold imports reflects a sustainable revival in domestic demand.” Controlling this revival will be key to containing inflation.
The biggest concern of any central bank is that inflation is joining domestic and business expectations, weakening wage negotiations in tightening labor markets. While the March RBI household survey showed a still very limited growth in three-month expectations, the impact of the recent input cost uptick is likely to be passed on to end-consumer prices across several segments, shifting these expectations upwards. likely to do. Combine this with already tight labor markets and evidence of closing “output gaps” in some tech-oriented sectors, and the concern becomes real.
Now what, going forward? The MPC will look to raise the real repo rate to 0% or more, perhaps in FY23 itself, or early FY24, to close the gap between the nominal repo rate and expected inflation. While inflation is likely to remain a problem for at least a few months, we believe that the MPC and RBI will not raise the repo rate in a predetermined way; Strictness will be driven by data and evidence. There is a lot of uncertainty in the outlook for the future. Anyway, rate tightening by G-10 central banks will lead to a slowdown in global growth and trade, which has already been predicted by the International Monetary Fund, the World Bank and the World Trade Organization. Faster domestic tightening could slow growth, which is consistent with overcoming inflation.
The author is Executive Vice President and Chief Economist at Axis Bank. Thoughts are personal.