The backdrop for the forthcoming monetary policy committee meeting to be held this week has sharply altered since the February meeting owing to financial stability risks emanating from the US banking sector.
On the domestic front, the monetary policy normalisation has led to rate hikes of 250 basis points so far and a significant tightening in liquidity balance with the real rates turning positive at 0.1 per cent in March 2023 from -3.8 per cent in April 2022.
Even as CPI inflation has continued to remain outside the RBI’s target range of 2-6 per cent for yet another month in February, the record high foodgrain production and a favourable base effect will keep it contained going forward.
Given this backdrop, it is prudent for the Reserve Bank to decouple from the global tightening cycle and pause its rate tightening spree. Private sector investments are slowly but steadily recovering and would require support from lower borrowing costs in the economy.
Importantly, given the fact that monetary policy works on lowering inflation only with lags, it is pragmatic that the lagged impact of the rate hikes is allowed to percolate into the system, and not stifle demand by further rate hikes. Aside from this, there are several other reasons which support a rate pause at this juncture.
Domestically, the transmission of the RBI’s rate hikes has picked up since December, and key rates have either surpassed or reached close to the pre-pandemic five-year average. The interbank liquidity surplus has sharply narrowed to $0.1 billion in March 2023 from $82.9 billion in March 2022.
This has started to have a material impact on the business sentiments, as attested by the results of the latest round of CII Business Outlook Survey (for 4QFY23) which reveals that ‘tight financial conditions’ has been cited as the top business concern followed by slowdown in global growth.
Moreover, there are also limits to how much interest rates can rise before they begin to suppress growth. We concur with the views of the two prominent MPC members who have rightly pointed out that India’s economic growth appears to be “very fragile”, with consecutive rate hikes having compressed demand. The pricing power of firms is also getting constricted as firms may hesitate to raise prices, given its negative impact on demand.
Thus, any more rate hikes by the RBI would raise the downside risks to real GDP growth, from the current expectation of around 6.5 per cent in FY24.
On the inflation front, CPI print has continued to remain outside the RBI’s target band owing to sticky core and food inflation. With oil and other commodity prices moderating, inflation is likely to remain contained.
Further, record foodgrains production is expected to have an ameliorative impact on food inflation, offsetting to some extent the adverse impact of El Nino if it were to occur this year.
Global financial stability has been met with another body blow in the form of the collapse of three banks in the US. This has brought to the fore the fault lines in the global banking system because of a near synchronised global monetary tightening pursued to contain inflation. The banking sector contagion as we have seen in the past has a swift percolation to the real economy through tightening of credit conditions.
To conclude, as food inflation has played a key role in driving CPI inflation, monetary tightening alone will not be enough to tame the inflation menace.
Consequently, countering inflation with aggressive rate hikes might not be enough to control supply-side inflationary pressures.
Hence, to tackle this supply-side issue, a fiscal response in the form of measures such as a limit on wheat exports and other commodities may be warranted.
The writer is Director-General, CII