By Saugata Bhattacharya
The Monetary Policy Committee (MPC), in a rare off-cycle review meeting on Wednesday, initiated a strong response to control inflation. The members unanimously voted to raise the policy repo rate by 40 bps (stronger than the conventional 25 bps), from 4% to 4.4%. The policy stance was retained, “with a focus on withdrawal of accommodation” from an ultra-accommodative mode.
In addition, the Cash Reserve Ratio (CRR) for banks was also raised by 50 bps, from 4% of banking Net Demand and Time Liabilities (NDTL) to 4.5%; this will drain Rs 87,000 crore from system liquidity from May 21. The CRR is considered to be more a liquidity management instrument rather than a monetary policy one, but given the rising concerns about the levels of surplus liquidity contributing to aggregate demand, it has become increasingly difficult to separate the effects on inflation.
These policy actions mark the formal start to the “tightening” process, although the communication indicates that the MPC still considers the actions as normalisation back to the pre-pandemic levels.
While there are many proximate reasons for the urgency of the off-cycle meeting, the exact one are still not very clear; there is little doubt that concerns regarding inflation getting entrenched in goods and services are now increasingly pertinent. To begin with, the March CPI inflation printed at 6.95%, much higher than the consensus 6.35%, and very broad based, with 66% of the Core CPI components printing above 6%. The April print is expected to be about 7.4%. The accompanying graphic shows the evolving inflation forecasts since February 2021. Inflation getting embedded is even greater a worry in the case of household and business inflation expectations, with fears of these expectations getting un-anchored, setting the stage for wage inflation and an inflationary cycle.
There were also some early warning signals, where we failed to connect the dots. For instance, RBI analytics infer that “every percentage point increase in surplus liquidity above 1.5% of NDTL causes average inflation to rise by 60 basis points in a year”, concluding that the large surplus liquidity overhang has to be withdrawn. Currently, surplus liquidity is above Rs 5.3 lakh crore, while 1.5% of NDTL is just over Rs 2.5 lakh crore; this implies that, post the higher CRR deposit, another Rs 1.7 lakh crore will need to be drained from the surplus to get to a neutral level of liquidity. Add to this RBI Deputy Governor Michael Patra’s observation in the minutes of the April MPC meet that “irrespective of whether supply bottlenecks are the driver or pent-up demand, it will become more difficult to tame inflation the longer the fight is delayed”.
Whatever the reasoning behind the front-loading, a couple of issues now need to be addressed. First, what might be the path (and extent) of the tightening cycle? Second, what are the implications for the range of interest rates on both market and banking and as a corollary, for the effect on credit flows to business and retail segments?
On the first, the evolution of macroeconomic trade-offs will determine the extent of tightening required. There are some signs that the “output gap” is closing. RBI survey showed capacity utilisation in manufacturing as of December 2021 at 72%, and this will only have gone up in March 2022. RBI Governor Shaktikanta Das noted that “persisting high growth in non-oil, non-gold imports reflects a durable revival in domestic demand”. There are other signs of companies increasingly passing on their higher input costs to end-consumer prices in varying amounts.
There has been talk about taking the real repo rate from the current deeply negative range upto zero or slightly above. This entails a view on inflation about a year ahead, and remains a dynamic metric. In any case, the repo needs to be taken up at least to the pre-Covid level of 5.15%. Given our understanding of the expected economic environment, MPC will probably choose a steady, pre-set hiking path to take the repo up to 5.25%, and, thereafter, increase to a “neutral” and terminal rate in a data- and evidence-driven response. The accompanying graphic shows the cycles in the RBI repo rate juxtaposed against the US Federal Reserve Funds target rate.
On the second issue of transmission, market interest rates have already gone up in anticipation of the policy rate hikes; the 10-year benchmark sovereign bond yield has risen from 6.2% around November 2021 (when VRRR rates started rising) to 7.2% now, pricing in almost the entire expected normalisation of the repo rate. Bank deposit rates have also started rising, together with the overall cost of funds. Given that over 40% of floating rate loans of banks are now External Benchmark Rate (mainly to repo) linked, these too will shortly start moving up.
India’s external financial conditions are likely to tighten sharply, with the steady increase in G-10 central bank rates. How best to calibrate domestic policy tightening “to ensure that inflation remains within the target, while supporting growth” will need all of RBI and MPC’s demonstrated agility.
The author is Executive vice president and chief economist, Axis Bank Views are personal