AN INEVITABLE AGGRANDISEMENT

AN INEVITABLE AGGRANDISEMENT

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May 9, 2022 - 10:35 am

RBI Hikes Repo Rate To 4.40% Over Elevated Inflation


     In a much expected move, the Reserve Bank of India (RBI) has increased repo rate by 40 basis point to 4.40%up from 4%  the cash reserve ratio (CRR) by 50 basis points to 4.50%  to suck out liquidity and bring down the elevated inflation. The rationale behind this decision was the upside risks posed by global factors to India’s inflation trajectory. The sudden action to hike was prompted probably due to some understanding within RBI about a higher retail inflation print in April, as harp hike in rate by US Fed, and deep worries over domestic food prices given their sensitivity in India’s political economy.

     In explaining its decision to raise borrowing costs for the first time in 45 months, the MPC has acknowledged that the overall outlook for inflation has darkened considerably since it met last month. Prices are on a tear globally and inflationary pressures are broadening worldwide. Even as the real economy struggled with millions losing livelihood, financial markets began looking for signals from central banks on when they would take away the punch bowl. Central banks initially saw supply disruptions caused by the Covid pandemic driving prices. Then it shifted to shortage of semiconductor chips. Then, the capacity constraints that came because of holding up of investments due to the Environmental, Society and Governance or ESG standards. Then came the sanctions on Russia - and now it's generalised.

     Prime Minister Narendra Modi’s government will not like short-term rates to go up all the way to 6.25% because that could mean long-term sovereign bond yields of 8% or more, something India hasn’t seen on a sustained basis since the aftermath of the 2013 taper tantrum. (The 10-year yield surged to almost 7.4% after the unexpected RBI move.) Higher interest rates may complicate the financing of a record $200 billion government borrowing program, bigger than even in the first year of the pandemic. Costlier capital could also pour cold water on a recovery in private investment that policy makers have been desperately waiting for.

    In recent times, there has been marked variance between actual inflation and the RBI's forecasts. In its February policy, the RBI had projected inflation at 4.5 per cent for 2022-23. Two months later, it raised the forecast to 5.7%. However, considering current trends -- global commodity prices remain elevated, food price pressures are likely to continue, and core inflation remains elevated signalling that price pressures are broad based—it is increasingly likely that inflation will come insignificantly higher than even the revised forecast, more so in the first half of the year. In fact, it is quite likely that actual inflation will surpass the upper threshold of the RBI's inflation targeting framework for three quarters of this year as well. Breaching the threshold will compel the RBI to write to the government to explain the reasons for its failure to rein in prices, and recommend remedial action. No central bank will relish the prospect of having to explain why it missed keeping inflation within the target. Consistently under estimating inflation will also raise questions over the central bank's forecasting abilities, and erode its credibility.

    Inflation hurts the poor and the middle-class more than it affects the rich. It also squeezes the smaller firm that isn’t able to absorb higher commodity costs the same way that a large company can by sacrificing overhead. Many of India’s small- and midsized enterprises have only survived the pandemic with the help of government-guaranteed emergency loans. Now that the RBI has stopped being in denial about prices, the more vulnerable producers and consumers will expect it not to stop prematurely. Let the government do its best to protect growth while managing its finances. The central bank has to go back to fulfilling its inflation mandate.

    Analysts are now expecting more rate hikes by the RBI in the coming months. The sharper than expected rate increase by the RBI paves the way for a more aggressive rate hike cycle than we earlier expected. The fact that the novel coronavirus is still lurking and it could trigger a fresh wave of infections, as seen in China, adds considerably to the uncertainty. Monetary authorities have also rightly pointed to the impact that the increases in domestic pump prices of petroleum products have had on inflation. The onus is now squarely on the RBI and fiscal authorities to move in lockstep and take every possible measure including cutting fuel taxes to keep inflation from running away and landing the economy in stagflation.

Questions and Answers Questions and Answers

Question : What was the rationale behind the RBI hikes Repo Rate to 4.40% over elevated Inflation?
Answers : Upside risks posed by global factors to India's inflation trajectory.
Question : How much did India's sovereign bond yield rise after the RBI move?
Answers : 7.40%
Question : How many government borrowing programs does higher interest rates complicate the financing of?
Answers : $200 billion
Question : What has occurred in recent times between actual inflation and the RBI's forecasts?
Answers : Marked variance
Question : How much did the RBI forecast inflation for 2022-23?
Answers : 4.5 per cent
Question : What will the RBI do to the government to explain the reasons for its failure to rein in prices?
Answers : No central bank will relish the prospect of having to explain why it missed keeping inflation within the target
Question : Inflation hurts what?
Answers : Poor
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