Reserve Bank of India Falls In Line With Global Central Banks

Every analyst swears today that on June 8, at the end of the three-day meeting of the Monetary Policy Committee (MPC), Indian central bank’s rate-setting body, there will be another rate hike. There is no consensus though on the quantum of the hike.

Will it be 75 basis points (bps)? Or, will the Reserve Bank of India (RBI) stagger it over two MPC meetings in June and August to raise the repo rate to the pre-pandemic level of 5.15 per cent? Or, will it take even longer to do so? No betting, but I will not be surprised if it is done in two stages by August. One bps is a hundredth of a percentage point.

After the outbreak of the Covid-19 pandemic, the policy repo rate was pared sharply in two stages to 4 per cent from 5.15 per cent in March and May 2020.?On both occasions, the rate cut happened off-cycle, advancing the MPC meetings.

There was also a one percentage point cut in banks’ cash reserve ratio (CRR) – the money banks keep with the RBI –from 4 per cent to 3 per cent, to increase liquidity in the system as well as a cut in the reverse repo rate by the RBI, without involving the MPC. The CRR cut, a one-time measure, was reversed after a year.

The repo rate is the rate at which banks borrow from the RBI while they park their excess money at the central bank’s reverse repo window. As the system was flooded with excess liquidity, the 3.35 reverse repo rate became the effective policy rate till the RBI introduced variable reverse repo rate (VRRR) auctions in January 2021.

Even before the pandemic, between February and October 2019, the RBI had cut the repo rate by 110 bps from 6.25 per cent to 5.15 per cent, and allowed excess liquidity in the system, to lift the sagging growth in Asia’s third largest economy.

Why are we speculating a 75 bps rate hike in June? Take a close look at RBI Governor Shaktikanata Das’s statement. After raising the rate to 4.4 per cent last week,?this is what he said: “... in response to the pandemic, monetary policy had shifted gears to an ultra-accommodative mode, with a large reduction of 75 bps in the policy repo rate on March 27, 2020 followed by another reduction of 40 bps on May 22, 2020. Accordingly, the decision of the MPC today to raise the policy repo rate by 40 bps to 4.40 per cent may be seen as a reversal of the rate action of May 22, 2020…”

So, there won’t be any surprise if at the next meeting in June itself, it reverses the March 27, 2020 action.

Incidentally, in 2020, the MPC meetings were advanced to cut rates. This time around, it was an intermittent meeting for the rate hike, and the June meeting remains on schedule. This strengthens our belief that there will be another round of hike in June. And, more rate hikes will follow.

Last week,?around 12 hours before the US?Federal Reserve raised its policy rates by 50 bps, the highest in 22 years, to tackle the worst inflation America has witnessed in four decades, the RBI raised the repo rate?by 40 bps to 4.4 per cent. Simultaneously, the rate of standing deposit facility (SDF), which has replaced reverse repo, has risen to 4.15 per cent. It has also raised the CRR by 50 bps to 4.5 per cent, which will drain Rs87,000 crore from the system. This was a unanimous decision by the six-member MPC.

The decision to raise rate in the US,?following a 25 bps hike in March (a first since late 2018),?was also unanimous by all 12 members of Fed’s policy-setting body, Federal Open Market Committee (FOMC). More such 50 bps rate hikes are on the cards for the next few FOMC meetings.?The US is also starting shrinking its bloated balance sheet by running off?$30 billion worth of treasury bills and $17.5 billion worth of mortgage-backed securities every month between June and August, before raising these amounts to $60 billion and $35 billion, respectively, in September.

A day after the Fed rate hike, the?Bank of England (BoE) raised its policy rates by 25 bps to 1 per cent, the highest since 2009, as Britain is staring at a deadly combination of recession and inflation upwards of 10 per cent. In this case, the decision was not unanimous; BoE’s nine-member rate setting body voted 6-3 for the raise.

In its April meeting, the MPC had left both the policy rates and the stance of the policy unchanged. Of course, while?the MPC unanimously decided to remain accommodative, it decided to focus on the withdrawal of accommodation “to ensure that inflation remains within the target going forward, while supporting growth”.?There was also a?shift in the RBI’s approach: In its scheme of things, tackling inflation came ahead of ensuring growth.

Still, the sudden off-cycle rate hike, a month ahead of the next MPC meeting, has taken everyone by surprise. Till recently, the RBI spoke about decoupling India from the other markets as the nature and threat of inflation is very different here. Then, why this sharp U-turn? Couldn’t it have waited till the June MPC meeting?

I guess the threat of inflation has forced the RBI to take this call. Retail inflation surged to 7 per cent in March, the highest in 17 months and above the upper limit of the central bank’s flexible inflation target band (4 per cent +/- 2 per cent) for the third successive month. Most analysts believe that in April, retail inflation, to be announced this week, would be above 7.5 per cent. And, it will remain above the upper end of the band for months to come, driven by high oil prices and food as well as core or non-food, no-oil, manufacturing inflation.

The rationale behind the sudden rate hike is “lowering inflation and anchoring inflation expectations”. Incidentally, the latest RBI report on currency and finance has said liquidity in excess of 1.52 per cent of net demand and time liability, a loose proxy for bank deposits, is inflationary. Currently, it is double of this. So, excess liquidity has to be drained. The?RBI has spoken of gradual liquidity withdrawal over a multi-year timetable. Can it afford to do so? Also,?theoretically lower interest rates could have an impact on the local currency, which has so far remained stable.

One can argue that the RBI has chosen to be reactive instead of being proactive and the rate hike cycle could ideally have started in April. Why delay falling in line with other central banks? But it has regrouped fast and reacted without losing time. Any delay would have been costlier.

In April,?the inflation forecast was raised and the forecast for growth for the year was cut. While the average inflation forecast for FY23 was raised by 120 bps from 4.5 per cent (estimated in February) to 5.7 per cent, the forecast for growth was cut by 60 bps to 7.2 per cent. In June, we may see the RBI raising the average inflation forecast to above 6 per cent even as growth estimates may also be tempered down. The 10-year bond yield, which was 6.91 per cent in early April, has now risen to 7.45 per cent.?

The cost of government borrowing will rise. Managing the record high borrowing programme in FY23 will be as challenging for the RBI as managing inflation and ensuring growth.

This column first appeared in Business Standard