RBI monetary policy: Pace of tightening set to slow

It is almost given that the Monetary Policy Committee (MPC) will signal a slower pace of tightening at its upcoming review, as downside risks to growth outweigh the upside risks to inflation. But more consequential will be what the Reserve Bank of India says about the pace of tightening from there.

Since the last policy review on September 30, the economic landscape has changed in many ways. Outlook for the global economy has further soured due to the ongoing war in Ukraine and the months of disruptive Covid-19 lockdowns in China. Many parts of the world, especially European nations, are expected to contract during 2023 in cumulative gross domestic product (GDP). The minutes of the early November meeting of the US Federal Reserve revealed a pessimistic view of its staff economists about the US economy during 2023. A substantial majority of the voting members said they believe in slowing the rate of interest rate increases from the next meeting as the US Fed’s goal is to get inflation under control without plunging the economy into a recession.  

Despite the ongoing global headwinds, the Indian economy grew impressively during H1, FY23 at 9.7 per cent, thanks to the robust performance of agriculture & allied sectors, contact-intensive services and resilient private demand. However, mining and manufacturing sectors — the main pillars of job creation — continue to remain weak. Both these sectors posted a sharp contraction in Q2 of FY23. Furthermore, India’s declining investment rate is one of the important reasons behind its high unemployment rate. A decline in the investment rate from 39.1 per cent in 2007-08 to 34.7 per cent in H1 FY23 is quite significant. The post-Covid boom in corporate earnings seems to have ended in Q2FY23, as companies witnessed a shrinkage of margins and profits due to higher costs. Trade deficit problem has resurfaced on account of global economic slowdown. As exporting sectors are primarily the job creators, “contraction” in exports doesn’t augur well for the employment scene.     
      

Fortunately, inflationary pressures have started moderating both globally and domestically. Globally, Brent crude prices have eased from $116/bbl in May to $86/bbl in November 2022. A softening trend is also observed in the global prices of metals & minerals. Domestically, the ongoing progress in kharif harvesting and rabi sowing bode well for food inflation going forward.

Given this growth-inflation mix, there is a strongly felt need to stagger rather than front-load the interest rate increases. Our financial system needs more time for the broad-based transmission of the past concentrated increases in the repo rate (190 basis points in just four months). While transmission so far has happened effectively and almost proportionately in all retail financial products linked to the external benchmarks, it is still lagging on term-deposit rates. Given the level of uncertainty, perhaps banks do not wish to raise term-deposit rates proportionately. They seem to depend more on one-year CDs or bulk deposits for funding requirements. As MPC member J R Varma has highlighted, this is coming in the way of stimulating savings and dampening consumption demand.

Given the pressures of domestic demand, the repo rate has to increase further. But at this stage, the MPC would like to signal a more gradual approach to strike a fine balance between inflation management and investment confidence. As expected by the MPC and professional forecasters, if India’s inflation cools to 5 per cent or less in Q1FY24, then a modest increase of 25 bps in the repo rate on December 7 will take the real rate to 1.15 per cent and keep the policy rate above the neutral rate.

A looming recessionary scene in the global economy and India’s elusive private capex cycle warrant that our monetary policy remains in a gradual, data-driven mode and avoids aggressive tightening going forward.

The writer is group chief economist, L&T Financial Services. Views are personal.