RBI hikes Policy Repo Rate and CRR to address Rising Inflation

Dr Debesh Roy, Chairman, InsPIRE

In the face of an unabated rise in inflation, the Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI), in an off-cycle meeting held on 2^nd and 4^th May 2022,  decided to raise the policy repo rate by 40 basis points (bps) to 4.4 per cent, and the cash reserve ratio (CRR)  by 50 bps to 4.5 per cent. This is the first hike in repo rate after almost two years.

The timing of the hike came as a surprise to the financial markets, with the Sensex crashing by 1,307 points, or 2.29 per cent lower than the previous day’s close (3^rd May 2022). However, it was expected by economists that the MPC would start raising the policy repo rate anytime soon during FY23, as CPI inflation remained above RBI’s tolerance level of 6 per cent during the three months January-March 2022. Inflation in March 2022 was much above the tolerance limit at 6.95 per cent. The inflation outlook remained grim in the context of rising food prices, apart from the rise in global prices of crude oil, wheat and sunflower oil due to global supply disruptions on account of the Russia-Ukraine conflict.  

Further, the decision by Indonesia to ban exports of palm oil, due to fall in domestic production on account of labour shortage in the country, has resulted in a sharp rise in price of edible oils in India, which depends on imports from Indonesia for 60 per cent of its demand for palm oil.

The MPC in its previous meeting during 06-08 April 2022 had decided to remain accommodative while focusing on withdrawal of accommodation to ensure that inflation remains within the target going forward, while supporting growth. In its off-cycle meeting, the MPC using an almost similar language, continued to maintain an accommodative stance, while focusing on withdrawal of accommodation to ensure that inflation remains within the target going forward, while supporting growth.

The MPC has stated that inflation would “rule at elevated levels, warranting resolute and calibrated steps to anchor inflation expectations and contain second round effects”. Given RBI’s projection of 5.7 per cent inflation during FY23, which could well be revised upwards, it can be expected that the RBI would increase the policy repo rate going forward by 75 bps to touch the pre-pandemic level of 5.15 per cent by end March 2023. Further, the CRR hike by 50 bps will result in an upward pressure on interest rates while withdrawing system liquidity by an additional INR 87,000 crore.

While loans to retail and micro, small and medium enterprises (MSME) borrowers, linked to the policy repo rate will become costlier with immediate effect, interest rates on corporate loans will rise within a month or so. Following the decision of the RBI to raise the policy repo rate, Bank of Baroda and ICICI Bank raised their external benchmark-linked lending rates by 40 bps each.

While costlier loans to productive sectors would have an adverse impact on India’s growth prospects, the country can still maintain its position as the fastest growing large economy in the world, with the government having prioritized investment in infrastructure, while also carrying forward its agenda of structural reforms, in addition to a focus on export-oriented manufacturing through the production linked incentive (PLI) scheme, and investment in education and health.