The decision of the Monetary Policy Committee (MPC) to hike the repo rate by 50 basis points, to 5.40 per cent, was not a major surprise, even though a tad stronger than our baseline expectation of 35-40 bps. Still, the overall communication of the RBI and the MPC was more hawkish than anticipated.

While the prices of some of the industrial commodities and food items softened in recent weeks, with persistence of supply chain disruptions, renewed geopolitical concerns and volatility in cross-currency movements, policymakers clearly opted to stay strongly vigilant at this juncture and erring on the side of caution, if needed.

The RBI drew comfort as regards growth recovery based on a set of indicators, such as industrial capacity utilisation, credit growth, government capex and PMIs, as the central bank kept its 2022-23 growth forecast of 7.2 per cent unchanged.

Rapid hikes

With all the six members in favour of a 50 bps hike, the MPC has delivered 140 bps hike in the repo rate in less than three months, by far the fastest pace of rate hikes in recent years.

Meanwhile, the liquidity surplus in the banking system also continued to move lower. It might be interesting to figure out the central bank’s stance on the preferred level of the banking system liquidity as we move further closer to the festival months and busy season for credit growth.

While prior to the latest meeting, one expected the terminal repo rate in the current cycle to be at 5.75 per cent with a modest downside bias, the RBI’s communication suggests that rate hikes are not over yet. Accordingly, the likelihood of the terminal repo rate of 5.75 per cent is clearly on the cards, even with the possibility of a modest upside.

Interestingly, one of the MPC members did not support the monetary policy stance of “withdrawal of accommodation” and perhaps preferred a more cautious stance.

The RBI announcement clearly prompted the fixed income markets to expect more rate hikes ahead, leading to the 10-year benchmark bond yield to climb higher to around 7.30 per cent, about 20 bps higher than the intra-day low observed prior to the MPC communication.

Even if the current approach means a somewhat slower recovery immediately, the central bank stays focused on financial stability and long-term sustainability of growth.

In the context of deciding on the terminal policy rate, a factor will likely be the share of assets books of the banking system that reflects external benchmark linked rates (EBLRs) — at over 40 per cent now as against a tiny single-digit number in the previous hiking cycles — which is witnessing nearly instantaneous and complete pass through of the central bank’s rate signals.

The deficit problem

Another set of factors that might have contributed to the RBI’s thought process at this stage is the unusually large trade deficit in recent months, FII outflows during the summer, and potentially a sizeable deficit on both current and capital accounts. While the rupee also touched the psychological mark of 80 against the dollar recently, one sees this as a result of generalised dollar strengthening despite the rupee outperforming a large number of other currencies.

Also, India’s trade gap will likely narrow in H2 of 2022-23. Furthermore, the RBI is not only using a part of its sizeable forex portfolio to support the rupee, several other policy initiatives on the part of both the RBI and the government (example, measured trade restrictions, rupee settlement in external trade, greater flexibility for banks as regards non-resident deposits) should also help materially in the coming months in containing rupee weakness.

Overall, the MPC clearly chose to stay cautious, a broad stance that will likely continue in the late-September MPC meeting also. However, incoming data on the evolving growth-inflation dynamics both at home and abroad, and external sector situation will play a key role in determining the MPC’s bias subsequently.

Our baseline expectation is that, barring further unforeseen surprises, a relatively less challenging backdrop as regards these parameters may allow the MPC to keep the repo rate unchanged during H2 FY23.

The writer is Chief Economist & Head of Research in Bandhan Bank. Rahul Goenka also assisted in providing inputs for this article. Views are personal