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A race up the rate hike mountain is on. Last week, the US Federal Reserve hiked policy rates by 75 basis points (bp), and such is the current level of market dystopia that this week, Federal Open Market Committee members still had to clarify that it is not turning dovish. The European Central Bank also hiked rates for the first time in more than a decade, similar to the UK, Canada, Australia and New Zealand. With the inflation iceberg likely right ahead, central banks, particularly in developed markets, are frenetically turning their ship’s wheel to change course towards policy tightening.

Unsurprisingly, the Reserve Bank of India (RBI) too has changed course after accommodating elevated inflationary pressures for long to avoid upsetting the growth applecart. Since May, it has hiked the policy repo rate by 90bp and squeezed liquidity. However, RBI has proceeded with caution, delivering both rate hikes and ambivalent guidance. Two hikes down, and it has still shied from changing its policy stance from ‘accommodative’ to ‘neutral’, coining the term ‘withdrawal of accommodation’ instead.

The minutes of the June policy meeting confirmed two key paradigms in the thinking of monetary policy committee (MPC) members. First, there seems a broad consensus that current inflationary conditions call for front-loaded rate hikes.

Second, there seems little consensus on where policy rates should ultimately settle. While one member suggested that we’re already there, another has argued that RBI’s 90bp hike comes on the heels of the official inflation forecast rising by 100bp, hence it has effectively been only treading water. Deputy RBI governor Michael Patra believes the policy rate should be at least above the one-year-ahead inflation forecast. Consequently, the MPC’s terminal repo rate guidance currently ranges from 5% to 7%.

Since this meeting, however, there have been two key developments. First, upside risks on inflation have eased. Typically, monsoon months experience a sharp month-on-month surge in vegetable prices. However, trends in July suggest that a crash in tomato prices is likely to bring overall vegetable inflation down. Prices of other food commodities have also moderated, as have some non-food global commodity prices.

Second, external sector worries have intensified. Globally, synchronized slowdown concerns, sticky inflation and hawkish central banks in developed markets make for an anxious external environment for emerging markets. India’s merchandise trade deficit breached yet another record high of $31 billion in July, suggesting our current account deficit in 2022-23 is likely to average an elevated 3.3% of gross domestic product (GDP). The rupee has sharply weakened against the dollar, with RBI rummaging through its policy and reserves war-chest to strike a balance between tackling this currency volatility and letting it somewhat float.

So what does this mean for the MPC meeting on Friday? First, it would be premature to declare victory over inflation. Domestic prices are generally sticky, so while the fall in global commodity prices has helped ease firms’ margin pressures, it will take time to translate into lower retail prices. In addition, crude oil prices remain sticky at close to $100 a barrel. Uneven rains, and lopsided sowing patterns, particularly for rice, could push up prices. There has also been a sharp revision in electricity tariffs in a number of states, while cooking gas and kerosene prices are also on the rise. As the service sector reopens, core services inflation is likely to stay elevated. We are also alert to second-round effects, through higher inflation expectations, wages and rents, leading to a persistence of core inflationary pressures. On balance, we do not believe there is a compelling case for RBI to change its 2022-23 inflation forecast of 6.7%.

Second, while it might be tempting to think RBI should hike policy rates to defend the currency, it’s not the best idea for two reasons. One, interest rate differentials are not the only factor that sway global investors. And importantly, two, it is not the MPC’s mandate. The very rationale of moving to a flexible inflation targeting framework was that this panel should react to inflation, with an eye on growth, and not be distracted by multiple objectives.

Our baseline view is that RBI will hike its policy rate by 35bp to 5.25% on Friday, although there is a likelihood of a more front-loaded hike of 50bp. With policy rates gradually inching towards neutral, we expect RBI’s stance to also change finally from ‘withdrawal of accommodation’ to ‘neutral’. In addition, we cannot rule out other measures aimed at encouraging capital inflows as indirect measures to address rupee volatility.

Beyond August, high uncertainty means that visibility is likely to be low. While inflation could trend lower hereon, the pace of moderation may not be as sharp. Hence, we believe more rate hikes would still be warranted. However, this also needs to be juxtaposed against the view of a looming recession in several countries, amid geopolitical risks and sticky inflation. Consequently, we recently reduced our terminal repo rate expectation to 6.00% from 6.25%.

After all, when visibility is low, it’s best to drive carefully.

Aurodeep Nandi is India economist and vice-president, Nomura.

 

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