A July 17 report by Hyun Song Shin, economic adviser and head of research, Bank for International Settlements, titled “Inflation and the path of soft landing” says front-loaded rate increases are more likely to result in a soft landing than back-loaded rate increases.
In a recent speech in Delhi, the Reserve Bank of India (RBI) Governor Shaktikanta Das has said, “Our endeavour has been to ensure a soft landing.”
The three-day meeting of the Indian central bank’s rate-setting body, Monetary Policy Committee (MPC), ends on Friday. It’s given that the RBI will go for a rate hike, but the question is: How much? Will it frontload the rate hike or go for a small dose, preferring to wait and watch how the scene unfolds?
The RBI had raised its policy rate by half a percentage point to 4.9 per cent in June, after an off-cycle 40-basis points (bps) rate hike in May. One basis point is a hundredth of a percentage point.
Will it go for yet another 50-bps rate hike this time around? Or settle for a 35-bps hike to raise the policy rate to 5.25 per cent, slightly higher than the pre-pandemic level (5.15 per cent). Some economists are evening expecting a 25 bps rate hike, just to bring it back to the pre-pandemic level.
Before we seek answers to these questions, let’s take a close look at what has changed since the June policy — in India and overseas.
The 10-year bond yield has softened from 7.518 per cent to 7.32 per cent but, at the shorter end, the 364-day treasury bill yield has risen from 6.12 per cent to 6.33 per cent. The liquidity in the system, which was ~3.16 trillion in June, has shrunk to around ~76,000 crore. There are many reasons behind this: The RBI’s dollar sale (for every dollar it sells, an equivalent amount of rupee is sucked out of the system); rise in money in circulation and perhaps the lack of government spending.
As liquidity tightens, the weighted average of overnight call money rate in the interbank market has risen beyond the repo rate — the rate at which banks borrow money from the RBI.
Among other things, retail inflation, which was 7.04 per cent in May (the last figure available before the June policy), dropped marginally to 7.01 per cent in June. During this period, the price of Brent crude has dropped from $120.57 a barrel to $109.58. And the rupee, which was priced at 77.71 a dollar, is now trading at 79.27 after crossing the 80 mark.
Meanwhile, India’s foreign exchange reserves have dropped to their 20-month low of $571.56 billion from their peak of $642 billion. Around the time of the last policy, the pile was $596.5 billion. Besides the RBI’s dollar sale, the devaluation of other currencies against dollar, too, has contributed to the depletion of forex reserves.
Barring the Russian central bank, which has cut the rate to 8 per cent from 9.5 per cent in response to a slowdown in inflation and improved GDP forecast, most central banks across the globe have raised policy rates since the last MPC meeting.
The US Federal Reserve leads the pack with a two-stage 150-bps rate hike to fight rising inflation (9.06 per cent). The European Central Bank has raised the rate by 50 bps for the first time in more than 11 years as it tries to control sizzling eurozone inflation (8.6 per cent). The Bank of Canada has raised the overnight rate by a full percentage point — the biggest increase since 1998. At 2.5 per cent, the current rate is the highest since 2008 (inflation 8.13 per cent) and the Bank of England has raised the rate 25 bps, for the fifth time in a row (inflation 9.4 per cent). The Swiss National Bank, too, raised its policy rate for the first time in 15 years, by 50 bps — from -0.25 per cent to -0.75 per cent — joining other central banks in tightening monetary policy to fight resurgent inflation.
Among other central banks, Hungarian National Bank has raised rates 380 bps and Czech National Bank and National Bank of Poland 125 bps each. All three countries are seeing double-digit inflation, ranging from 11.7 per cent to 17.2 per cent. The list is not complete.
Against this backdrop, what do we expect from the RBI?
Ideally, it should go for a 50-bps hike, taking the repo rate to 5.4 per cent. Why am I saying so? Primarily for two reasons: high inflation and a depreciating rupee.
Assuming a normal monsoon and average crude oil price of $105 per barrel, the RBI has projected inflation at 7.5 per cent in the first quarter of FY 2023; 7.4 per cent in the second quarter; 6.2 per cent in the third; and 5.8 per cent in the fourth quarter, ending in March 2023. In February, it had estimated just 4.5 per cent average inflation for FY23. The Russia-Ukraine war and its impact on oil price, among other things, forced it to up the estimate to 5.7 per cent in April before it raised to 6.7 per cent in June.
The MPC’s inflation target is 4 per cent with a band of 2 per cent on either side. In April, retail inflation was at an eight-year high of 7.79 per cent, almost double the target.
Retail inflation has been above the upper limit of the central bank’s flexible inflation target band since January 2022 and, by RBI’s own projection, it will remain so till December.
With commodity and food prices softening, inflation will probably undershoot the RBI projection, but the worry is core inflation — it remains sticky and high. When it continues to remain well above 6 per cent for long, only a dramatic drop in food and fuel prices can bring headline inflation down.
The recent fall of the local currency adds a new dimension to the RBI’s challenges. The Federal Reserve has been raising interest rates faster than most other central banks, drawing capital flows to the US. The only way to protect the value of the rupee is to not allow the gap between the US and Indian policy rates to widen.
A 50-bps rate hike can be followed up by another 25-bps hike at the next MPC meeting, taking the repo rate to 5.65 per cent. Is that the nominal rate the RBI should aim at? Or should this be 6 per cent? It’s difficult to say at this point as there are too many uncertainties around but at that level the RBI can wait and watch for the next step.
At the same time, I will not be surprised if the central bank prefers to go for a 35-bps hike now, instead of 50 bps. The reasons? Well, most analysts believe that the worst on the inflation front is behind us; the fourth quarter inflation could be below the RBI estimate of 5.8 per cent and in the next fiscal year it will come down to around 5 per cent.
Have we seen the worst for the rupee? With most global central banks responding to the US Fed rate hikes, the attraction for the US as a destination for capital is diminishing. The greenback may not continue with the runaway appreciation against most currencies. The dollar index, which was 102.31 in June, is now trading at 106.08 after touching 108.54 intra-day once but, from now on, it should move downwards. Besides, with recession staring at it and likely weakening of inflation, the Federal Reserve will not pursue rate hikes with aggression. This will reverse the direction of the US currency.
In essence, the RBI can justify a lower dose of rate hike in sync with its calibrated approach, but I would root for a 50-bps hike for now to demonstrate its resolve to fight inflation and stem deprecation of the rupee. Then it can cross the river by feeling the stones.