By Suvodeep Rakshit
The key debate for the RBI MPC in the August policy will be on the quantum of rate hike and what signal will accompany it. While a 25 bps hike is ruled out, market opinions are split between a 35 bps hike and a 50 bps hike. We believe that a 50 bps hike will be appropriate in this policy to acknowledge (i) elevated but gradually falling inflation, (ii) being in sync with global monetary policy while reacting to domestic macro situation, (iii) addressing external sector pressures by managing interest rate differentials, and (iv) continuing to frontload the rate hikes. Arguably, the quantum of hike is finely balanced within the 35-50 bps range.
The RBI’s deliberations will likely be centered around (1) global monetary policy cycle and outlook for global growth, (2) external sector imbalances manifesting in pressures on the INR, (3) recent easing of global commodity prices, and (4) domestic inflation and growth trajectory. The RBI will also note that since the June policy, the Fed has surprised on the upside with hikes of 150 bps over the June and July policies. We believe that while domestic inflation concerns may be slightly lower, external sector concerns warrant caution.
We expect inflation to gradually glide towards 4.5-5% by March 2023 even as it hovers around 7% till September. The government’s measures across sectors such as energy, metal, and food along with softer global prices will continue to ease inflationary pressures. Importantly, 1QFY23 inflation at 7.3% is 20 bps lower than RBI’s estimate in the June policy
Given the fall in commodity prices and unchanged auto fuel prices, 2QFY23 inflation could be 30-40 bps lower than RBI’s estimate of 7.4%. Similar downside is possible in 4QFY23 inflation estimates amidst pass-through of tighter monetary policy and lower global commodity prices. While we pencil in a front loaded 50 bps hike in the August policy keeping in view the external sector pressures, the inflation outlook could provide comfort for the RBI to hike by 35 bps.
We note that since the April policy the weighted average call rate (WACR) has increased by around 175 bps given the introduction of SDF rate, repo rate hikes, and tightening liquidity. The June RBI bulletin had estimated India’s natural interest rate at 0.75-1%. The bulletin mentioned that “when the real policy rate is at or close to the natural rate, monetary policy is neutral”. In this context, the repo rate of 5.75-6% with inflation averaging within 4.5-5% in FY2024 could be in sync with this natural interest rate. Additional rate hikes, if any, would then depend on the degree of internal (inflation) and external (current account) imbalances in the economy.
Risks to domestic inflation remain on the upside in case of (1) continued pass-through of high input prices, (2) pass-through of higher crude prices to domestic pump prices, and (3) higher food prices due to weak monsoon or lower acreage. Geo-political tensions and implications for energy prices will remain a risk for inflation. Along with inflation, the RBI will be mindful of the external sector imbalances too. Trade deficit can remain wide in case of relatively sharper fall in exports due to global demand slowdown. Rapid dollar strength has led to some sharp INR depreciation. Depreciation risks for the INR would increase if the Fed (or other DM central banks) were to raise rates beyond current expectations in case inflation remains sticky and elevated. While the RBI has used the FX reserves as the primary defense, given the uncertainty, FX focused measures (including on interest rates) cannot be ruled out. Prospects of global growth slowdown and its impact on India’s growth could soon be central in monetary policy deliberations.
Given the current and prospective risks, the RBI would ideally prefer to retain flexibility in its actions rather than strait-jacket itself into a predetermined policy path. The RBI’s objective of front-loading the rate hikes should be served well through a 50 bps repo rate hike to 5.25% while shifting to a data-dependent policy action from here on. This should help in retaining the hawkish stance while acknowledging some incipient softening in inflation trajectory.
(Suvodeep Rakshit is Senior Economist in Kotak Institutional Equities. Views expressed are the author’s own.)