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MUMBAI : The Reserve Bank of India roiled markets with a surprise interest rate hike in an out-of-turn policy meeting while moving to drain excess liquidity in the banking system, as the central bank set out on an aggressive path to tame runaway inflation.

The RBI’s rate-setting panel raised the repo rate by 40 basis points to 4.4% after nearly two years of keeping the rate at which it lends to commercial banks steady. In addition, the central bank also raised the cash reserve ratio (CRR) by 50 basis points to 4.5% to suck out 85,000 crore of excess liquidity from the banking system. One basis point is 0.01%.

Graphic: Mint
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Graphic: Mint

Accordingly, the statutory deposit facility, the rate at which banks park excess liquidity with RBI without any collateral, will now be 40bps higher at 4.15%, and the marginal standing facility, or the rate at which banks borrow from RBI in an emergency at 4.65%.

Despite the rate hike, the monetary policy committee decided to continue with its accommodative policy stance while focusing on the withdrawal of accommodation. Governor Shaktikanta Das explained that the rate hike should be seen as a reversal of the rate action of 22 May 2020.

Interestingly, RBI’s move came hours before the US Federal Reserve announced a 50 basis points increase in interest rates, a move that could severely pressure the Indian currency. Moreover, a sharp depreciation in the currency will increase import costs, further fuelling inflation and depleting the country’s forex reserves.

“The timing of the hike is important, too, as it seems to just precede a likely 50bps increase in the policy rate by the US Fed. This is possibly to ensure that the rupee is safe from any speculative attacks, notwithstanding the Life Insurance Corp. of India IPO, and especially as the forex reserves are down by around $30 billion (to $604 billion) from its peak levels," said Indranil Pan, chief economist, Yes Bank.

Although most economists expected a 25 bps rate hike in June, the surge in inflationary pressures following the Russian invasion of Ukraine might have forced RBI to take a larger-than-expected rate hike sooner.

“The MPC judged that the inflation outlook warrants an appropriate and timely response through resolute and calibrated steps to ensure that the second-round effects of supply-side shocks on the economy are contained, and long-term inflation expectations are kept firmly anchored," Das said in an online briefing. “Inflation must be tamed in order to keep the Indian economy resolute on its course to sustained and inclusive growth."

In the off-cycle meeting held on 2 and 4 May, the monetary policy panel reassessed the evolving inflation-growth dynamics since its last meeting in April. The committee outlined its worries around inflation, ranging from costly oil to food and core inflation. It also highlighted the stickiness of inflation, referring to the April retail inflation number, which is expected to be elevated, much like the March 6.95% reading.

Economists expect RBI to further front-load hikes because of the expected higher April inflation reading to be released later this month. As a result, the market is pencilling in a 25-50 basis points hike in the next meeting in June and an additional 75 bps in phases thereafter. “We expect RBI to now deliver at least a 50bps rate hike in the June policy meeting. We see RBI raising policy rates to 5.15% by August, and expect it will reassess macroeconomic momentum to gauge the need for further hikes beyond that," said Rahul Bajoria, chief economist at Barclays India.

The move is expected to provide crucial support to the rupee amid a capital flight from emerging markets. “RBI is worried about the impact of tightening global financial conditions on foreign capital flows and the rupee. Foreign portfolio investors have remained net sellers in India since October 2021. So far in 2022, the rupee’s depreciation has been moderate at 2.6%. However, RBI noted that India could not remain immune to external spillovers if global financial conditions tightened significantly. By raising the CRR, the RBI intends to mop up excess liquidity at a faster pace, to show its commitment to maintaining domestic financial stability," rating agency Crisil said in a note.

In February, RBI emerged as the lone central bank to maintain an accommodative stance and even revised its inflation projection sharply lower to 4.5% for the next fiscal, drawing criticism from many quarters. Later in April, the central bank raised its inflation projection to 5.7% for FY23. It expects the economy to grow 7.2% in FY23 from an earlier projection of 7.8%.

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