Surprising the markets is a favourite pastime of central banks. It was the Reserve Bank of India’s turn to surprise on Wednesday with a big 40 basis points hike in policy rates accompanied by a 50 basis points increase in the cash reserve ratio (CRR), decided in an unscheduled Monetary Policy Committee (MPC) meeting. The surprise was not so much in the action per se as in the timing. What changed between the last policy announcement on April 8 and Wednesday? All the reasons cited by Governor Shaktikanta Das for the hike now were existing a month ago. Three factors may explain the timing of this hike now. One, with the March CPI print nudging 7 per cent and April’s expected to be much higher than that, the RBI perhaps had to acknowledge that its inflation forecasts of 6.3 per cent for Q1 FY23 and 5.7 per cent for FY23 were at serious risk of being overshot. India’s Monetary Policy Framework holds RBI responsible and accountable should retail inflation overshoot the 6 per cent target for three consecutive quarters. Two, RBI may have been worried about the imminent Fed rate hike (expected at 50 basis points on Wednesday) triggering a taper tantrum-like episode for India, with an FPI exodus destabilising the external account and causing a slide in the rupee. Three, despite RBI’s attempts to soak up liquidity through the VRRR and SDF windows, domestic liquidity has remained stubbornly in the surplus this past month, stoking demand-led inflationary pressures. The 50 basis point hike in the Cash Reserve Ratio absorbing ₹87,000 crore, should partly help quell these pressures. But having said this, the losses to stock and bond market investors precipitated by this steep hike could have been avoided, had the MPC bitten the bullet on a 25-basis point hike in its April review and offered clear guidance.

Though the shock value of this rate hike sent the 10-year government bond yield up to the 7.4 per cent mark in Wednesday’s trade, bond markets are likely to digest this event quickly as they were already pricing in a 75-100 basis points hike for the full year. But policymakers will now need to assess the implications of the substantial rate hike on the economy, which was only now beginning to regain its pre-Covid animal spirits. Capex investment decisions depend more on the demand outlook for businesses, than on rate direction. But there’s now a significant risk of this sudden rate hike impeding the nascent recovery in sectors such as real estate and housing which have a big multiplier effect on the economy. Higher finance costs could also dull demand for consumer goods and extend the pain for the auto sector which is already struggling with scarcity and rising costs of inputs.

It is also moot if monetary measures alone can rein in runaway food and fuel inflation, with the big role played by global supply disruptions in this inflationary episode. Though a part of the spiral now could be attributed to abundance of liquidity (which the CRR hike addresses), the fact is that inflation is driven by supply-side events and not demand. This is something for the fiscal side to tackle. The Centre needs to act quickly to cut import duties on fuel, primary commodities and key industrial feedstock, and also address supply shortfalls so that the central bank’s surprise action doesn’t go in vain.

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