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A terminal repo rate of 6.5%?

Further upside can’t be ruled out as global rates, especially in the US, are likely to move higher.

A terminal repo rate of 6.5%?
According to the Reserve Bank of India’s (RBI) monetary policy report (released in April 2022), a 5% depreciation of the rupee from the baseline scenario could add 20 basis points to headline inflation.

By Anubhuti Sahay

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Consensus expects yet another repo rate hike at the September Monetary Policy Committee (MPC) meeting. A 50 basis points increase in the repo rate, taking it to 5.9%, can be expected, and more rate hikes could be seen over the next few meetings.

The terminal repo rate can be forecast at 6.5% by February 2023, and a further upside cannot be ruled out, as global rates, especially in the US, are likely to move higher. This is likely to pose upside risks to India’s inflation via a weaker currency channel. Additionally, a likely delayed withdrawal of an already uneven monsoon in India poses risks of higher food prices and thus headline inflation.

Ideally, domestic fundamentals (i.e. growth-inflation dynamics) are the key determinants of interest rate decisions by any central bank. However, in a globalised world, the ripple effects of decisions in other countries, especially in the major economies, have repercussions for monetary policy decisions in others, especially emerging markets (EMs). The same is true for India as well, which is a twin-deficit economy and a net commodity importer.

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With the rupee likely to stay under pressure from higher global rates—the Fed recently raised rates by 75 basis points and is widely expected to hike to 4.5% by mid-2023 —it is viable to have more rate hikes in EMs such as India so that the second-order effects of a weaker currency on inflation can be contained.

According to the Reserve Bank of India’s (RBI) monetary policy report (released in April 2022), a 5% depreciation of the rupee from the baseline scenario could add 20 basis points to headline inflation. The rupee has depreciated by about 2.7% since the beginning of September and the recent breaching of the 80-mark versus the dollar is an implicit indication of higher tolerance for a weaker rupee by the central bank.

One can argue that the rupee could have been kept at a stronger level to limit the risks of imported inflation. In fact, strong dollar selling by local banks helped to contain the pace of rupee depreciation under 80 over the past couple of months, possibly driven by the objective of containing imported inflation.

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However, with the dollar being consistently strong, a still-wide current account deficit (which can be expected at 3.8% of GDP for FY23), and cautious portfolio investment flows, a breach of the 80-mark against the dollar was inevitable. The defence of USD-INR around 80 led to a loss of import cover from a high of 13 months at the beginning of the year to close to nine months recently.

While an import cover of close to nine months underlines a strong external-sector buffer, lingering global uncertainty due to the risk of a global recession, along with higher commodity prices and interest rates, means that foreign exchange reserves need to be managed more prudently.

The strong pace of reserve accumulation by the central bank over 2020 and 2021 is unlikely in the next two-to-three years, while the current account deficit is likely to remain wide amid high commodity prices and relatively better growth in India versus the rest of the world.

In fact, allowing the rupee to better reflect fundamentals has reduced its overvaluation and could attract more flows as investors have been shying away, given the overvaluation concerns. As per Standard Chartered Bank’s real effective exchange rate (REER), overvaluation has reduced by c.1% since the breach of the 80-mark against the dollar.

Collateral damage in the form of higher imported inflation, in turn, has been managed by hikes made to the domestic interest rates. It can be said that the risks of imported inflation are likely to be contained as global commodity prices have corrected significantly from their peak in mid-June.

The increased upside risks to Standard Chartered Bank’s FY23 Consumer Price Index inflation forecast are acknowledged based on a likely delayed retreat of an already uneven monsoon. As of September 27, overall rainfall was 7% above the long-period average, with central and southern India recording rainfall that was c.20% above the LPA and eastern and northeastern India recording 15% below.

The distribution is highly uneven for paddy-growing states, and the crop output is widely expected to fall 8-10% in a base-case scenario. This could push up food inflation versus this author’s current forecast of 6.9%. Wheat prices are already facing upward pressure on account of lower output and reduced buffer stocks. Initial signs of rising food inflation are evident in the stronger-than-expected sequential increase in cereals inflation last month. Vegetable prices are also trending higher.

While clarity is awaited on the impact of rainfall on the agriculture output to better assess the inflation trajectory, an upside risk to Standard Chartered Bank’s CPI inflation forecast of 6% for the second half of FY23 (FY23 forecast: 6.6%) is anticipated. Currently, CPI inflation can be predicted to return to below the upper threshold of the mandated band (6%) by March 2023. The MPC is mandated by law to keep headline CPI within the band of 2-6%, with 4% being the medium-term target. In case inflation stays above 6% for longer than anticipated, more rate hikes than expected could be witnessed.

Meanwhile, even as India’s growth recovery remains uneven, it is likely to stay reasonable with the start of the festival season. The services sector is also likely to boost growth momentum from the release of pent-up demand. A continued recovery should create more space for the MPC to focus on containing upside inflation risks. A much higher interest rate would impact the growth recovery adversely. However, front-loading the growth impact by raising rates can help to reduce the growth pain and risks to macro-economic stability later on.

RBI has so far taken measures to ensure macroeconomic stability; by raising rates, it is likely to ensure stability in the medium term as well (even as it comes at a cost in the short term).

The writer is Head-South Asia, Economics Research, Standard Chartered Bank

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