Home / Opinion / Views /  RBI could no longer ignore the gathering dark clouds in the inflation front

And so it begins, the much-anticipated reversal of India’s interest rate cycle. The Reserve Bank of India (RBI) could no longer ignore the gathering dark clouds and had to finally bite the interest rate bullet. Yet, it is quite likely that in the coming days the crux of discussions will not be so much the rate action but the proximate reasons for the precipitous action, the extent of the rate increase, the manner in which the decision was taken, and, the panoply of rates that has now emerged.

The RBI increased the benchmark repo rate by 40 bps on Wednesday, by convening an off-cycle meeting of the Monetary Policy Committee between May 2 and 5, a month after the first formal meeting of 2022-23 in April and a month before the next scheduled round takes place. Along with the repo rate, the upper end of the rate corridor – the marginal standing facility (MSF) and the Bank Rate – and the new lower bound (standing deposit facility, SDF) have all been bumped up by 40 bps as well, to maintain the symmetrical 25-bps headspace and bottom wiggle room. The central bank has also increased the mandatory cash reserve ratio (CRR) by 50 bps to 4.5%, which will hoover up 87,000 crore of cash from the system.

The reverse repo rate, of course, lies forgotten. But before singing a lament for this neglected monetary policy tool, it might be advisable to examine the probable reasons for RBI’s off-cycle rate call.

The first unavoidable reason for RBI jumping the bimonthly monetary policy ritual is the steady metronome of a rising inflation rate. The consumer inflation index crossed 7% in March and the April print is unlikely to provide any relief. The wholesale price index, an indicator of producer prices, has been in double digits for almost a year now. Food and fuel prices remain elevated. And though the domestic economy was showing some early signs of revival, global headwinds are likely to present some challenges. The combination of a rising inflation rate and an impending slowdown in economic growth could entrench high inflation rates for longer periods. This will make inflation a self-fulfilling phenomenon in the economy.

But, then, there is also the issue of timing. The central bank could have increased interest rates a fortnight ago, or even a month ago at the financial year’s first bimonthly MPC meeting. Little has changed since then: the spill-over effects from the Russia-Ukraine conflict were still as detrimental, and the inflationary storm was blowing even then. In fact, even the bond markets were expecting some rate action in April. But, instead, the RBI has decided to increase its rates hours before the USA’s Federal Reserve hiked its dollar interest rates by 50 basis points.

In hindsight, it would seem that the central bank is somewhat concerned about the reversal of short-term external flows after the Fed’s decision. A large chunk of India’s foreign exchange inflows is believed to be rate-agnostic; conversely, short-term flows tend to be rate-sensitive and any abrupt disruption in flows could induce near-term exchange volatility, further contributing to the build-up of inflationary pressures in the system.

The RBI has been content to let the rupee float down gently over the past few weeks. However, given the unrelenting price pressures on food and fuel prices globally, as well the continuing supply chain disruptions (exacerbated by the lockdown in China), there is a risk of the current account deficit widening, and governor Shaktikanta Das admits it as well: “The worsening of terms of trade, driven by higher commodity prices could have implications for the current account deficit in 2022-23, but it is expected to be comfortably financed". Despite these brave words, his timing seems to give him away: he is clearly trying to minimize the consequences of the Fed’s monetary policy normalization on India’s inflation rate, via financial flows and exchange rate volatility.

The RBI has said that the monetary policy would remain broadly accommodative, even while reducing excess liquidity in the system to maintain the tricky balancing act of supporting growth while trying to limit inflation within the target zone. This hints at the possibility of a marginal acceleration in the conduct of variable rate reverse repo auctions and SDF absorptions. The CRR hike should help achieve that objective partially, though this could have a marginal dampening effect on bank earnings.

A quick word about the extent of the rate hike: 40 bps. The clue to the reason behind this odd number lies in the governor’s statement. This latest increase takes the benchmark repo rate back to the level prevailing before 22 May 2020, when it was cut by 40 bps. The rate, though, is yet to get back to pre-pandemic levels; that is, before the RBI made its first deep cut of 75bps on 27 March 2020. So, belt up, because it seems rates have a steep incline to climb hereafter.

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