Walking the tight rope

Updated on: Jun 09, 2022
Reserve Bank of India Governor Shaktikanta Das addresses a press conference at RBI headquarters on Wednesday

Reserve Bank of India Governor Shaktikanta Das addresses a press conference at RBI headquarters on Wednesday | Photo Credit: SHASHANK PARADE

The sharp hike in rates by the MPC was inevitable, but the real challenge is to control inflation without hurting growth

The Monetary Policy Committee’s decision to increase the repo rate by another 50 basis points to 4.90 per cent, after a surprise 40 basis-point hike last month, comes as no surprise. After its deliberations this week, the MPC has come around to the view that inflation is proving to be a bigger problem than it had visualised just two months back. It has done the right thing by hiking the repo rate once again after May, signalling its intent to snuff out inflation. The ‘accommodative stance’ has finally been set aside, after more than two years. The feeling does linger that the process of normalising policy could have begun two months back, when it was clear that the Ukraine war would keep food, commodities and energy prices elevated for some time to come. Yet, the MPC’s April inflation forecast for FY23 was 5.7 per cent, whereas it has now been revised sharply upward to 6.7 per cent, well above the mandated upper band of 6 per cent. In terms of the factors driving prices skyward, little has changed since April. The MPC seems to have reassessed the situation. It has projected a Q1 and Q2 inflation rate of 7.5 per cent and 7.4 per cent, respectively, with Q3 and Q4 rates tapering off to 6.2 per cent and 5.8 per cent, respectively. As a result of this late realisation, the first two rate hikes of the current cycle have been rather steep.

A rate hike controls inflationary expectations and shores up the rupee, now buffeted by capital outflows to safe havens, as conceded by the RBI Governor. A stable rupee — the rupee has apparently done better than its peers by depreciating just 2.5 per cent this fiscal — can check imported inflation. Meanwhile, an increase in repo rate is good news for savers hit by steeply negative real returns, particularly when banks are expected to pass on the benefit. This is indeed likely, as the rush to lure deposits may begin to meet rising credit demands, as liquidity gradually drains out of the system. In keeping with a rise in capacity utilisation (from 72.4 per cent in Q3 to 74.5 per cent in Q4 of FY22) and high frequency indicators, bank credit growth was up 11.1 per cent in April. A good monsoon would spur credit demand, provided the weathermen, and MPC, are right.

The MPC also leaves some questions unanswered. It has said that inflation is driven by supply-side, ‘imported’ factors, which is indeed the case; the latest GDP data points to muted private consumption demand. But rate hikes are no answer to supply side problems. The solution lies in fiscal measures such as, for example, a cut in taxes on fuels by States, as the RBI Governor has advocated. Whether excessively sharp hikes will choke nascent signs of a revival in investment is an issue worth keeping in mind. That said, a moderate rate hike in the next policy seems inevitable in this volatile environment. Excess liquidity persists despite the RBI’s liquidity withdrawal measures. While the surplus in the system is down from ₹7.4 lakh crore in April to ₹5.5 lakh crore in May, this is more than enough to meet emerging credit needs, as a result of which short-term money market rate is still below the repo rate. Additional liquidity withdrawal steps can perhaps be reinvoked as a price control measure. The RBI has to walk a hard tightrope between controlling inflation through various means, and not unduly sacrificing growth.

Published on June 08, 2022
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