Before the pause

Overall conditions call for another rate hike

The Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI), which started its last meeting for the fiscal year on Monday, has a relatively difficult decision to make. Since the inflation rate was above the upper end of the tolerance band for over three quarters, which legally meant that the central bank failed to attain the target and had to write to the government as mandated by the law, there was clarity in terms of decision-making. The rate-setting committee had no option but to increase the policy interest rate, which had been earlier reduced to tackle pandemic-related disruption. As a result, it has raised the policy rate by 225 basis points so far in the current cycle. The RBI is also in the process of unwinding excess liquidity, which has resulted in the tightening of financial conditions. However, macroeconomic conditions have changed since the last meeting. Inflationary pressure is easing globally and growth outcomes are expected to be somewhat better.

The International Monetary Fund’s (IMF’s) January update of the World Economic Outlook shows that the global economy is expected to grow 2.9 per cent in 2023, which is 0.2 percentage point higher than its October forecast. The slowdown in advanced economies has not been as severe as anticipated earlier. Economic growth in the US in 2023, for instance, has been revised upward by 0.4 percentage point. The global economy, nonetheless, is expected to slow considerably this year, with aggregate growth being about one percentage point lower than the long-term average (2000-2019). Inflation conditions are also easing, though the rate in advanced economies remains considerably above target. According to IMF projections, about 84 per cent of all countries are expected to have lower inflation in 2023 than in 2022. Compared to the average of 8.8 per cent in 2022, global inflation is expected to ease to 6.6 per cent in 2023, and further to 4.3 per cent in 2024. The 2024 level, however, would still be higher than the pre-pandemic level of 3.5 per cent.
 

The Consumer Price Index-based inflation rate in India also moderated to below 6 per cent in November and December. The MPC in its last meeting had projected an inflation rate of 5 and 5.4 per cent for the first and second quarter of 2023-24, respectively. It is likely that the projection would be revised lower. Even as the headline number is lowered, it would be important to see expectations on core inflation, which has remained sticky. Higher core inflation will be a risk for durable moderation in the headline number. As things stand, another 25-basis-point repo rate hike, along with some moderation in the projected headline inflation rate, will take the real policy rate closer to the desired level.

Thus, the decision the MPC will need to make would be to either raise the rate now to take it to what appears to be the near-terminal rate or wait for some time. It makes sense for the RBI to increase the policy rate by 25 basis points now and signal that future action would depend on data. A rate hike after a pause would not have the desired impact. Central banks in advanced economies, including the US Federal Reserve, are likely to increase rates further before pausing. The RBI will thus need to watch the impact of a further tightening of global financial conditions on India’s external position even after taking the policy rate to the desired level.