In an unexpected move, the Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI) unanimously delivered an off-cycle hike in the repo rate of 40 bps and the cash reserve ratio (CRR) of 50 bps in May 2022, a month before the next scheduled policy review.
The MPC also decided unanimously to remain accommodative, while focusing on the withdrawal of accommodation to ensure that inflation remains within the target going forward, while supporting growth. Contrary to the market’s expectations of a change in the stance from accommodative to neutral in June 2022, the RBI Governor has clarified that monetary policy is shifting gears back from an ultra-accommodative mode.
Today's surprise repo rate and CRR hikes are very well timed, in our view, with our own CPI inflation projection for April 2022 spiking to an eye-watering 7.4 per cent from nearly 7.0 per cent in March 2022, with commodity prices remaining elevated in the wake of the Russia-Ukraine conflict and supply concerns arising from the Covid situation in China.
Moreover, the broad-basing of inflationary pressures has emerged as a cause for concern. The share of items in the CPI basket that witnessed a sequential increase in prices surged to 78 per cent in Mar 2022 from 68 per cent in Jan 2022 and 70 per cent in Feb 2022. These levels are well above their respective pre-pandemic (FY17-20) averages, implying that price increases have been relatively generalised in the recent months. This widening of inflationary pressures is likely to impart stickiness to the inflation trajectory going forward, pushing the FY2023 average CPI inflation print above 6.0 per cent. Additionally, more than half of the 299 items in the CPI basket had reported a YoY inflation rate higher than the MPC’s upper limit of 6.0 per cent for the fourth consecutive month in March 2022.
By advancing the rate decision by approximately one month, the MPC has focused on preventing inflationary expectations from un-anchoring in an increasingly uncertain environment, replete with geo-political volatility.
The 50 bps increase in the CRR is expected to result in a withdrawal of liquidity amounting to Rs. 870 billion. Nevertheless, the average surplus liquidity in the banking system will remain at elevated levels, with the RBI’s continued assurance of ‘gradual withdrawal over a multi-year time frame’.
As of now, we see a higher base softening the May 2022 CPI inflation print, although it will remain above 6.0 per cent. While a back-to-back hike in the June 2022 policy is not yet certain, we do foresee an additional 35-60 bps of rate hikes in the remainder of H1 FY2023. If a de-escalation in geopolitical tensions cools commodity prices, then we expect a pause to reassess the impact on growth, followed by another 25-50 bps of rate hikes in CY2023. This entails a terminal rate of 5.5 per cent, in our view, as growth concerns are unlikely to disappear completely.
The surprise move expectedly caused G-sec yields to jump. If the US Federal Reserve's decision tonight is more hawkish than expected by the markets, then the 10-year G-sec yield could test 7.5 per cent as early as tomorrow, the cap that we had foreseen for H1 FY2023.
(Aditi Nayar is the chief economist at ICRA Limited. Views expresed in the article are her own.)