RBI monetary policy review: Direction for repo rate is clearly northwards

The monetary policy announced by the RBI on Wednesday was to throw a different kind of surprise. It was not a case of whether the Monetary Policy Committee (MPC) would raise the repo rate but by how much. The estimates varied from 25 bps to 75 bps with the forecasts based on what the market felt would be the terminal point of the repo rate this year. The MPC pitched for a high number of 50 bps, which is significant because if combined with the inflation forecast, it indicates that more hikes are coming.

Future decisions will be guided by the movement in inflation, which has now been stubborn for over two years, though is being noticed more now. The reason is that till February the RBI maintained that growth was more important and as it did not look durable, one could bear up with inflation, which though around the 6 per cent level, looked manageable. The Russia-Ukraine war has changed everything.

The matrix is now clear. Inflation will be higher than expected at 6.7 per cent but the growth forecast has been retained at 7.2 per cent. Inflation will be at 7.5 per cent and 7.4 per cent in the first two quarters followed by 6.2 per cent in the third. This means that there will be reasons for further increases in the repo rate and another 50-75 bps looks highly likely under these conditions with an upside to further increases.

While the forecasts per se are not scary and hence the market should not be worried by these numbers (10-year yield came down to less than 7.5 per cent), the direction for the repo rate is clear and it is northwards. The interesting thing is that a large part of the portfolio of bank loan books would be linked to external benchmarks and when it is the repo rate, the potential for one hundred per cent swift transmission is extremely high. This is good for the banks though not necessarily for the SMEs and home loan borrowers, which tend to borrow at benchmark rate plus spread.

Now, will increasing the repo rate to even 5.15 per cent - which was the rate before the pandemic struck - help tame inflation? The answer is that it cannot bring down prices that are guided by global forces like war, oil prices or by scarcity of wheat in the international markets. But it will stop the buildup of excess demand forces and hence will run a parallel engine to control inflation while the government takes a call on excise and taxes (which has already been done) to have a direct impact. But for sure inflationary expectations come down which can be self-fulfilling in the medium term. This will be an accomplishment.

The positive news given by the RBI is that growth will be at 7.2 per cent, which is also the house view at Bank of Baroda. This is significant because if combined with rate actions expected, one can expect inflationary expectations to be quelled and hence not come in the way of growth. High inflation it should be membered has the potential to denude discretionary consumption as people spend more on necessities.

The language in the statement has always been of interest to the markets because from the stance of being accommodative there has been the use of the concept of withdrawal of accommodation. This has been done through the stopping of GSAPs and later an increase in CRR. The policy has cleared doubts on this concept and hence while RBI will provide funds when required (it will be talking about the government borrowing programme separately) all extraordinary measures are to be withdrawn.

Savers can be happy with these rate hikes as though the deposit rates will not increase immediately and commensurately; they will be headed northwards as credit recovers and banks hike rates to meet this demand.

Madan Sabnavis is the chief economist at Bank of Baroda and the author of: Lockdown or economic destruction. Views are personal