RBI Intensifies its Attack on Spiraling Inflation

Dr Debesh Roy, Chairman, InsPIRE

The Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI) on 8^th June 2022, unanimously decided to raise the policy repo rate by 50 basis points (bps), the steepest increase in more than nine years, to 4.9 per cent. This is the second hike in the repo rate in just over a month, adding up 90 bps from 4 per cent set in May 2020, with a view to controlling inflation, aggressively. While the RBI was behind the curve to control inflation till the April MPC meeting, it took a decisive step to control spiraling inflation by raising the first repo rate hike in two years by 40 bps in the off-cycle MPC meeting  on 4^th May 2022.

The MPC has increased the inflation forecast by 100 bps to 6.7 per cent for fiscal year (FY) 2022-23, and has projected an inflation rate of 7.5 per cent, 7.4 per cent, and 6.2 per cent for Q1, Q2 and Q3 of FY23, respectively. For the first time since the flexible inflation-targeting framework was introduced in October 2016, for policy repo rate setting by the MPC, the RBI, in all likelihood, will fail to achieve its mandate – which is to keep the average inflation at 4 per cent with a +/- 2 per cent tolerance limit – for three consecutive quarters. As per the mandate, RBI would need to explain to Government of India the reasons for inflation exceeding the upper tolerance limit of 6 per cent for three consecutive quarters.

Inflation is now a global phenomenon, due to the Ukraine-Russia war, Covid-related lockdowns in China and global supply chain disruptions. As stated by RBI Governor Mr. Shaktikanta Das, “The war has led to globalisation of inflation. Not surprisingly, central banks are reorienting and recalibrating their monetary policies. Emerging market economies (EMEs) are facing bigger challenges from increased market turbulence, monetary policy shifts in advanced economies (AEs) and their spillovers. The process of economic recovery in EMEs is also getting affected”.

The MPC also decided to drop the accommodative stance to “remain focused on withdrawal of accommodation to ensure that inflation remains within the target going forward, while supporting growth”. As RBI has embarked on an aggressive policy tightening cycle,  the MPC is expected to resort to calibrated tightening and could  decide on two more hikes of 25 bps each in FY23, taking the repo rate to 5.65 per cent by March 2023.

However, there could arise a risk of a wide divergence from RBI’s inflation projections, which could result in a sharper rate hike. Research by SBI shows that RBI could factor in a rate hike in August and even October MPC meetings, and take the repo rate higher than pre-pandemic level by August to 5.25 per cent and in October to 5.5 per cent. The peak rate at the end of the cycle, according to the SBI report now has a lower bound of 5.5 per cent and could go up to 5.75 per cent, depending on inflation trajectory.

Banks have raised their lending rates in response to the rise in the repo rate. This will cause borrowers to pay higher equated monthly instalments for their loans. Further, the demand for loans by retail as well as corporate borrowers would fall, restricting economic activities.

The RBI, however, has kept its growth forecast unchanged at 7.2 per cent for FY23,  with Q1, Q2 and Q3 growth at 16.2 per cent, 6.2 per cent,  4.1 per cent; and 4.0 per cent, respectively, with risks broadly balanced. According to the MPC statement, the recovery in domestic economic activity is gathering strength due to the following factors:

• Rural consumption should benefit from the likely normal south-west monsoon and the expected improvement in agricultural prospects;
• A rebound in contact-intensive services is likely to bolster urban consumption, going forward;
• Investment activity is expected to be supported by improving capacity utilisation, the government’s capex push, and strengthening bank credit;
• Growth of merchandise and services exports is set to sustain the recent buoyancy.

However, the MPC has warned that spillovers from prolonged geopolitical tensions, elevated commodity prices, continued supply bottlenecks and tightening global financial conditions nevertheless weigh on the growth outlook.