Known unknowns

Global developments need careful monitoring

At a time when the Indian economy and financial markets are dealing with uncertainties at multiple levels, the Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI) did well to not surprise the market last week. The rate-setting committee increased the policy repo rate by 50 basis points to 5.9 per cent. The standing deposit facility and marginal standing facility rates were adjusted accordingly. Given the inflation situation, the rate will need to be increased further. To what extent the MPC will raise it in the current cycle will depend on a variety of factors, including developments in the currency market. The RBI expects the inflation rate to moderate to 5.8 per cent in the last quarter of 2022-23 and 5 per cent in the first quarter of next fiscal year. The Monetary Policy Report, also released on Friday, showed the RBI expected the inflation rate to average 5.2 per cent in 2023-24, assuming its assumptions hold.

Although it would still be significantly above the target of 4 per cent, the RBI will get some policy space for adjustments. But as things stand, the inflation rate is likely to remain above the tolerance band for three consecutive quarters, which will be regarded as a failure to achieve the target. Consequently, the RBI will have to write to the Union government, explaining why this happened, the action proposed by the central bank, and the expected timeframe by which the target will be achieved. It is, however, not clear at this stage if the communication will be made public. The government and the RBI would do well to make it public. This would make the process transparent. Not releasing it will set an undesirable precedent and affect market confidence.

While the RBI’s inflation forecast for the year is broadly in line with market expectations, its growth projections will be tested in the coming quarters. As the official April-June quarter growth estimates came significantly below the RBI’s projection, it revised the full-year forecast modestly to 7 per cent from 7.2 per cent. In the process, it increased the growth projection for the second half of the fiscal year to 4.6 per cent, compared to the earlier forecast of about 4 per cent. This is intriguing. It can be argued that if the first-quarter estimates had come in line with what the RBI expected, it would have had to revise the full-year forecast upwards at a time when growth estimates are being lowered all over the world.

Global conditions, in fact, will significantly affect outcomes in the coming months. There is no sign of geopolitical tensions easing. Increasing stakes in the Ukraine war could not only affect commodity prices but also increase risk aversion and tighten global financial conditions. Meanwhile, the US Federal Reserve is expected to continue to increase interest rates, which would affect capital flows and currency valuations. While the RBI has rightly maintained that policy is determined by domestic conditions, sustained rupee depreciation could affect inflation outcomes. In this context, it is worth noting that about 67 per cent of the decline in foreign exchange reserves in the current fiscal year has happened because of dollar appreciation and higher US bond yields. Reserves adequacy and diversification will, therefore, need to account for such stress conditions. Global developments will need to be carefully monitored over the next few months.