While the timing and the quantum of tightening by the Reserve Bank of India (RBI) may have surprised the markets, a withdrawal from the ultra-loose policy was always on the cards. It is good thinking on the part of the central bank to front-load the hike in the repo rate with a chunky 40 bps raise and to top that up with a 50 bps increase in the cash reserve ratio (CRR). By doing this, RBI has redeemed itself in the eyes of many who felt India’s central bank was way behind the curve. Quite a few market players also believe that the central bank was unnecessarily hesitant to accept that the inflation was not a transitory phenomenon, given the nature and consequences of the Russia-Ukraine hostilities.
To be sure, the 40 basis points hike in the SDF (standing deposit facility) to 3.85% in April, was hiking by stealth. There was a clear shift in RBI’s stance to one that was “less accommodative”, and the central bank had made it clear it was prioritising inflation concerns ahead of growth. However, given crude oil prices were ruling above $100/ barrel, it could perhaps have raised the repo rate at the policy meet in early April.
Nonetheless, it has done well not to wait until June and take action before the April inflation numbers are out. RBI’s big concern is that food inflation is turning out to be stickier than anticipated. Prices of edible oil have soared and high global prices of wheat are impacting domestic prices, even as there is some apprehension that the output will fall short of estimates. Also, the cost of agriculture production will head up, though the impact might be felt with a lag. Continued high food inflation would not just hurt the poor but could also alter inflationary expectations to a point where it hurts consumer spends. Unfortunately, there seems to be little respite as companies have started using their pricing power and will continue to do so; electricity too is set to become more expensive in about a year.
That would explain the central bank’s two-pronged strategy. Although RBI has taken several measures over the past few months to soak up the excess liquidity, it remains at a very high Rs 7.5 trillion. The 50 bps increase in the CRR will result in a sequestering of close to Rs 90,000 crore, and the higher SDF at 4.15% would also be used mop up liquidity. RBI has said it will remain ‘accommodative while focusing on withdrawal of accommodation…’, which it is, given the real policy rate is still significantly negative. Clearly, the process of normalisation will be taken forward in June perhaps with a 25 bps hike; as of now, a terminal repo rate of 5.5% by the middle of 2023 does not seem unlikely.
This would, of course, drive up the cost of retail loans immediately and that of corporate credit over time. The government will now need to pay a much higher rate; bond yields closed at 7.38% on Wednesday. Indeed, there are now significant downsides to growth as high inflation crimps demand and the rising cost of money stymies credit growth. The private sector capex cycle had begun to turn but might plateau in the medium term as companies wait for demand to stabilise. Already, global growth rates for 2022 have been lowered by 100 bps, the spillover effect of which will be felt in India, especially in terms of exports. While RBI must be mindful of this and step in to control the second-round effects of inflationary pressures as it has lowered India’s GDP growth forecast for FY23 to 7.2% in April. Else, the economy could fall into a deep rut.