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In trying to squeeze one last drop of output from an empty barrel of monetary elixir, India’s central bank made the serious mistake of not only ignoring the country’s inflation build-up, [in evidence for quite some time], but pretending that it didn’t exist. Now that the Reserve Bank of India (RBI) has surprised markets with an unscheduled 40 basis point increase in its benchmark interest rate, the so-called repo rate, the journey to recoup its lost credibility is finally underway. Chances, however, are that it will be a hard slog for RBI. While a campaign of tightening monetary policy is unavoidable under the country’s economic circumstances, the longer it goes on, the more it could annoy Indian politicians.

Even the US Federal Reserve seriously underestimated the risk of inflation last year, and has to play catch-up. [It raised its main policy rate by 50 basis points hours after RBI’s rate hike on Wednesday].

RBI’s policy errors are more recent. The central bank blew its February meeting by projecting price increases for the financial year ending on 31 March 2023 at a benign 4.5%. The central bank’s monetary policy committee (MPC) put its faith behind that cheery forecast even though the Indian bond market didn’t believe it: Private-sector estimates were by then already starting to coalesce around the top end of the central bank’s 2%-6% target inflation range. Still, market traders took the official forecast as a signal that RBI was going to ignore price pressures just to keep borrowing costs low for the Union government and give a helping hand to a still-incomplete recovery from the ravages of the covid pandemic.

However, by the time India’s February inflation reading came in at 6.1%—higher than the previous month’s 6% and outside the tolerance range—Russia’s invasion of Ukraine had begun. If RBI was behind the curve before the war, it wasn’t close to being on the right route after it.

After consumer prices rose nearly 7% from a year earlier in March, Nomura Holdings raised its forecast for rate increases by the third quarter of 2023 to 200 basis points, up from its previous estimate of 150. The terminal rate for RBI’s repo rate would be 6%, economists Sonal Varma and Aurodeep Nandi said. After Wednesday’s increase, which took the Indian benchmark rate to 4.4%, Nomura changed its terminal rate estimate to 6.25% by the second quarter of next year. The longer you delay normalization, the more of it you end up doing.

Prime Minister Narendra Modi’s government would 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 RBI’s unexpected move on Wednesday.) Higher interest rates from her onwards may complicate the financing of a record $200 billion government borrowing programme, bigger than even in the first year of the pandemic.

Costlier capital could also pour cold water on a recovery in private investment that policymakers have been desperately waiting for.

It’s catch-22. Trying to stoke weak demand with artificially low rates could have eventually threatened external stability. Foreign investors have pulled out more than $17 billion so far this year from the Indian equity market. The country’s $600 billion in foreign-exchange reserves may shield its currency this time around from the sort of intense selling pressure it witnessed after the Fed’s 2013 taper. Even so, a widening current account deficit, combined with RBI’s reluctance (till this week) to raise policy rates, hasn’t exactly inspired confidence in rupee assets.

The Nifty index of top 50 stocks was trading at 22 times forward earnings at the start of the year; that valuation has since shrunk to 19 times earnings. Yet, [going by net equity-market outflows since October], global investors are refusing to bite.

Inflation hurts the poor and the middle-class more than it affects the rich. It also squeezes smaller businesses that aren’t able to absorb higher commodity costs the same way that large companies can by sacrificing overheads.

Many of India’s small- and mid-sized enterprises have only survived the pandemic with the help of government-guaranteed emergency loans. Now that RBI has stopped being in denial about the country’s price trajectory, 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. India’s central bank must go back to fulfilling its inflation mandate. 

Andy Mukherjee is a Bloomberg Opinion columnist.

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