By Rajani Sinha
RBI Governor Shaktikanta Das has said a rate hike at the June 8 MPC meet is a “no brainer”. So, the economists are now breaking their heads on how much the hike will be and how the growth and inflation projections for FY23 will be revised? More importantly, what will be the path taken in the next few months given the fragile domestic economic recovery?
To answer these questions, let us first look at the inflation scenario. The main drivers of inflation in India are food and fuel, with food contributing around 50% in the past few months. But the big concern is that inflation is gradually becoming broad-based. Today, high inflation is not just in food and fuel, but also in other items of CPI such as clothing, footwear, transport, communication, recreation and personal care. According to the latest data, core inflation (excluding food and fuel) has touched a high of 6.8%. The concern for RBI is that high food and fuel inflation will not just have a second-round effect on other components of inflation but will also push up household inflationary expectations. This, in turn, could result in a wage-price spiral, further pushing up actual inflation. Though the government has announced measures that will cool inflation by 50-60 bps, the concerns remain.
In the next few months, CPI inflation is likely to be above 7%. However, with control measures being taken by RBI and the government, we could see some cooling of prices in H2 FY23. A likely slowdown in the global economy could also ease global commodity prices to some extent in the next few months. Considering all these factors, RBI is likely to hike the inflation projection for FY23 to around 6.5% from their earlier one of 5.7%.
While India is better placed in the global arena on the growth front, the economy is not unscathed from the global turbulence. GDP data for Q4 FY23 shows a contraction in the manufacturing sector and that’s worrisome. IIP consumer goods (both durables and non-durables) continue to be weak and weak consumer spending is problematic. Bank credit growth has jumped by 9.6% in March 2022, but credit demand by large corporates shows a dismal growth of 0.9%. The industrial sector is feeling the heat of high input prices and supply bottlenecks, while the services sector is bouncing back with pent-up demand. But even in the services sector, segments such as Information Technology will face the brunt of global slowdown, specifically the US. Going forward, India’s merchandise exports would also feel the pain of global growth slowdown.
RBI is facing a complex situation of fragile economic recovery and high inflation. To add to its woes, India’s external situation of widening CAD and strong FPI outflows also put pressure on RBI to raise interest rates further. With the financial markets prepared for rate hikes, the central bank would take this opportunity to increase policy interest rates by 35-40 bps in the next meeting. Going forward, the eventual target would be to move towards a positive real rate of interest. This implies that the repo rate would be hiked to 6.5% or so. However, RBI would be closely watching the global and domestic growth trajectory in the next few months to decide on the pace of its tightening. India’s economy is seeing a weak recovery, warranting the central bank to be cautious in its rate hiking cycle. Moreover, the global situation remains quite volatile with signs of economic slowdown. Hence, if the US growth falters, the Fed also may have to change its aggressive monetary policy tightening plans. This would change the rate-hiking plans of many other central banks, including India. For FY23, the central bank will hike the policy rate by 100-150 bps, depending on the inflation-growth dynamics.
As far as liquidity is concerned, RBI had hiked the CRR by 50 bps to reduce the abundant liquidity in the system. With net liquidity already reduced to around `3.5 lakh crore from `7 lakh crore in the beginning of the year, the central bank may not be required to take any further action in the upcoming meeting. With India’s balance of payments likely to move to deficit in FY23 and the pressure on rupee, RBI may have to continue intervening in the forex market to reduce volatility. This will keep the liquidity in the system contained.
The other critical aspect is that with the policy interest rate rising and the likelihood of additional borrowing by the government, there will be further strong upward pressure on G-Sec yields. So, will RBI announce further OMOs to prevent sharp rise in yields? In the current situation, when the central banks globally are looking at reducing the size of their balance sheets, RBI is unlikely to take recourse to this tool. This will be in conflict with RBI’s objective of reducing the liquidity in the system to make the policy rate hikes more effective. However, the Central Bank could take recourse to other tools such as operation twist to contain any sharp rise in yields if required.
All things considered, RBI has a tough task of controlling inflation while ensuring that growth does not suffer much. And given the volatile global situation, Governor Das would be closely watching the macro-economic environment to decide on anything.
The author is chief economist, CareEdge Group