Interest rate transmission to hasten following 50-bps repo hike

Ramnath Krishnan | Updated on: Aug 05, 2022
The RBI’s stance was more hawkish than expected

The RBI’s stance was more hawkish than expected | Photo Credit: FRANCIS MASCARENHAS

Inflation in the second and third quarters of this fiscal is likely to be lower than the MPC’s projections

The Monetary Policy Committee (MPC) hiked policy rates by 50 basis points (bps) in its August 2022 policy meeting, in line with the increase effected in June 2022, amidst a focus on anchoring inflationary expectations.

The commentary was more hawkish than what we had anticipated, given the moderation in global commodity prices and the improved CPI inflation outlook since the June 2022 policy meeting.

While the MPC retained it FY2023 CPI inflation projection at 6.7 per cent, it rebalanced its quarterly estimates, cutting the Q2 FY2023 forecast by 30 bps to 7.1 per cent and surprisingly raising its Q3 FY2023 forecast by 20 bps to 6.4 per cent. It maintained the Q4 FY2023 projection at 5.8 per cent and projected the CPI inflation to decline to 5.0 per cent in Q1 FY2024.

Moderating inflation

We believe that the Q2 and Q3 FY2023 prints would turn out to be more favourable than the MPC’s forecasts, with the likelihood of a sub-6 per cent print in Q3 FY2023. The progress of the monsoon, with risks from both high and low rainfall, and the trajectory of services inflation, given the demand recovery in the segment, would be key monitorables in the near term.

The Committee retained its growth projections for FY2023 at 7.2 per cent in the August 2022 meeting, in line with our own expectations. We, however, expect a lower (albeit double-digit) print for Q1 FY2023, on account of elevated commodity prices and the dip in Rabi wheat output in that quarter, counterbalanced by a better growth turnout in Q2-Q4 FY2023 than the MPC’s estimates.

In our view, the moderation in global commodity prices since mid-June 2022 will reduce the pressure on business margins and boost value-added growth in Q2 FY2023.

Growth boost

This could support growth in Q3-Q4 FY2023 also, if the commodity price down-trend sustains. However, risks have emerged on account of the flagging external demand and rising uncertainty amidst a global slowdown, which could curtail India’s exports and defer the anticipated broad-basing of private capex activity.

Amidst its second consecutive 75bps rate hike, the US Federal Reserve tempered its guidance and language in its July 2022 meeting following the softening in commodity prices amidst fears of a global recession. Given the time lag until the next Fed meeting, which is scheduled for end-September 2022, any expectations thereof would be premature at this juncture.

Notwithstanding the Fed’s future moves, we expect the MPC to be guided by domestic developments around inflation and growth, and be increasingly data dependent going ahead.

At present, we expect the MPC to hike policy rates by 10-35 bps in its meeting in September 2022, depending on how much higher the CPI inflation readings are than the 6.0 per cent upper tolerance limit of the inflation target band. This would take the repo rate to 5.5-5.75 per cent. Thereafter, we foresee a pause, amidst a continued moderation in the durable and systemic liquidity.

Vigilant RBI

The Governor’s statement has indicated that the Reserve Bank of India (RBI) will remain vigilant on the liquidity front and conduct two-way fine-tuning operations as and when required, both variable rate repo (VRR) and variable rate reverse repo (VRRR) of different tenors, depending on the prevailing liquidity and financial conditions.

For instance, the RBI had recently conducted a 3-day VRR on July 26, 2022 for an amount of ₹500 billion, which drew substantially higher bids of ₹1.5 trillion amidst the temporary frictional liquidity tightness caused by tax outflows.

Higher rates and tighter liquidity clearly foretell faster transmission going ahead. The money market rates were largely anchored around the reverse repo rate amidst the surplus liquidity seen during the last two years. With a moderation in surplus liquidity, overnight rates are likely to rise somewhat more than the policy rates, with the spread between the latter and the repo rate likely to narrow from the current levels.

Rising rates and the fear of mark-to-market losses have led to a sharp decline in corporate bond issuances, which touched a 4-year low in Q1 FY2023. Large borrowers have shifted to banks for their incremental funding requirements, boosting the year-on-year (YoY) non-food bank credit growth to a robust 13.5 per cent as on July 15, 2022.

Lagging deposit

However, deposit growth lagged at 8.4 per cent, making banks rely increasingly on certificates of deposit (CDs) to fund the incremental credit demand. Volumes of CDs outstanding rose 243 per cent as on July 1, 2022 on a YoY basis to ₹2.4 trillion.

With this, the gap between the yield on a CD compared to the average card rates on bank deposits has widened. With the expected hike in policy rates and the rising spread between money market rates and the card rates for deposits, we see an even sharper hike in deposit rates in the coming months.

 The writer is MD and Group CEO, ICRA Ltd

Published on August 05, 2022
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