Shifting gear

Prepare for rate hikes faster than expected

The Reserve Bank of India (RBI) last week decided to recalibrate its policy approach by shifting the stated focus back to price stability. Consequently, it normalised the policy corridor. However, instead of increasing the reverse repo rate, the RBI introduced another instrument called the standing deposit facility (SDF), which will act as the floor for the policy corridor. The central bank decided to keep the reverse repo rate unchanged, but it has been made somewhat redundant for normal circumstances. The introduction of the SDF gives more flexibility in managing liquidity and removes the constraint of providing collateral. The SDF rate will be 25 basis points below the policy repo rate, while the marginal standing facility rate would be 25 basis points above the repo rate. Thus, this restores the corridor to the pre-pandemic level of 50 basis points. The RBI would be well advised to not disturb the corridor as it did during the pandemic.

The Monetary Policy Committee (MPC), meanwhile, decided to keep the policy repo rate and stance unchanged but is now focused on the withdrawal of accommodation. It could have easily shifted the stance to “neutral” without disrupting the financial market. In fact, this would have given the rate-setting committee more flexibility in an uncertain economic environment. The MPC revised its inflation projection for the current fiscal year to 5.7 per cent. The quarterly projections, however, suggest there is a very high chance of the inflation rate breaching the upper end of the tolerance band for three consecutive quarters. The rate has been above 6 per cent in January and February. The March number too is likely to be above 6 per cent. The RBI’s projections suggest the rate will be at 6.3 and 5.8 per cent, respectively, in the first and the second quarters this fiscal year. It is worth noting here that the central bank has been underestimating inflationary pressures in recent times. The breach would be treated as a failure and warrants an explanation from the RBI. According to the law, the RBI will have to explain the reasons for failure in achieving the inflation target, and the proposed action to be taken in this context.

Therefore, it is likely that the MPC would have to act more aggressively. The RBI, for instance, has assumed the exchange rate at Rs 76 per US dollar. Given that India is likely to witness a higher current account deficit because of elevated commodity prices, and capital flows are expected to remain weak due to the tightening of global financial conditions, the rupee is likely to weaken. According to estimates, a depreciation of 5 per cent in the currency can push up the inflation rate by 20 basis points. The RBI would do well to not defend the rupee to contain inflation as it could create longer-term imbalances. The RBI’s crude oil price assumption too could come under pressure. Higher than expected tightening would affect economic recovery and growth. As the base effect fades in the second half of the fiscal year, growth is anticipated to slip to about 4 per cent. This should worry policymakers. While the RBI needs to focus on price stability, it’s for the government to find ways to push up growth in a sustainable way.