High prices won’t be the RBI's only reason for a rate hike

The domestic and external values of the rupee are interlinked and feed into each other. Photo: HT
The domestic and external values of the rupee are interlinked and feed into each other. Photo: HT


  • India, which imports most of its crude oil, is especially at risk of being trapped in inflation-exchange rate loop.

Inflation in India has stayed above the central bank’s upper tolerance limit for eight months now. Yet, when the monetary policy committee (MPC) hikes interest rates next week, rising prices won’t be the only reason. This year, the rupee has lost value both domestically through inflation, and externally through depreciation against the US dollar. The twin factors have complicated the MPC’s task of maintaining financial stability in a volatile global scenario. Let’s unpack.

This year so far, the rupee has fallen from 74.5 to a dollar to 79.8, a decline of nearly 7%. At the same time, consumer prices have gone up, on an average, by about 6.8%. Why does this matter? The domestic and external values of the rupee are interlinked and feed into each other: a prolonged period of high and rising inflation weakens the rupee by hurting India’s growth and competitiveness, and a declining exchange rate sets off inflation via higher import prices. India, which imports nearly all its crude oil, is especially at risk of being trapped in this inflation-exchange rate loop.

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Almost every emerging and advanced country’s central bank has tightened interest rates this year. As the rupee hovers near the psychologically sensitive 80-mark, the MPC may have no choice but to follow them even as the world deals with fears of an imminent recession. A fourth consecutive repo rate hike by the MPC—likely to be to the tune of 35-50 basis points (bps)—seems to be a foregone conclusion. (One basis point is one-hundredth of a percentage point.)

Rupee dynamics

The reasons for the fall in the rupee’s value can be grouped into two categories: factors that mainly drive up domestic prices, and those that mainly impact forex markets. The first category included the rise in food and fuel prices following Russia’s invasion of Ukraine, the rise in input prices, and pent-up domestic demand for services.

The forex market was mainly driven by rising US interest rates. As returns on US assets—already attractive by virtue of their safe haven status—rose to their highest level in decades, there was a massive reallocation of global capital into dollar assets. This strengthened the dollar, and as a corollary, weakened the rupee.

The sustained high inflation in the US means the Federal Reserve may continue to tighten rates even though inflation differentials between India and the US are narrowing. In such circumstances, another interest rate hike by India will help attract foreign investments and consequently dollar inflows, which will support the rupee.

Rupee and inflation

Typically, anyone transacting in forex faces more or less the same exchange rate at a point of time, but each household faces a different level of inflation based on their specific consumption needs. But this time, broad-based inflation across food, fuel, and services, has ensured the pinch has been rather secular.

The RBI acknowledges a close link between rupee depreciation and inflation: an April 2022 monetary policy report stated that a 5% depreciation could push up inflation by 20 bps. Not surprisingly, the RBI intervenes regularly in forex markets to “manage" the exchange rate. This is particularly important now, when much of the inflation can be attributed to external events.

The RBI governor recently made it clear that the central bank was in the market almost on a daily basis, not just to control volatility, but also to anchor expectations of rupee depreciation. A stronger rupee will make imported inputs cheaper, stemming inflation to some extent.

Export strength

Current global uncertainties make it tough to predict if and how much more the rupee will depreciate. A comparison with peer currencies shows that the rupee’s depreciation this year ranks in the top quartile of this group. Currencies supported by commodity exports (such as those of Malaysia, Brazil and Indonesia) depreciated less because their values were pushed up by higher commodity prices. Currencies of export-driven economies (such as South Korea and Thailand) fell more because their growth is likely to be hurt by a slowdown in the West.

India has the advantage of being driven by domestic consumption, but faces the challenge of being a net commodity importer. The upward march of the King Dollar threatens to bring replays of the inflation-exchange rate loop. In this context, while a rate hike by the RBI may not effectively break that loop, it will definitely weaken its impact in the near term.

Deepa Vasudevan is an independent writer in economics and finance.

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