Normalising policy

The pace of rate hikes could moderate

The Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI) did well to increase the policy repo rate by 50 basis points to 5.4 per cent last week. The standing deposit facility and marginal standing facility rates were adjusted accordingly to 5.15 and 5.65 per cent, respectively. A section of the market was expecting the committee to go slow, which was reflected in higher bond prices in the run-up to the policy meeting. However, the MPC had strong reasons to do what it did. Although the retail inflation rate has moderated in recent months, it still remains elevated and above the tolerance band of the RBI. The retail inflation rate was 7 per cent in June — the sixth consecutive month when it remained above the RBI’s upper end of the tolerance band. Since the MPC expects inflation to remain above the tolerance band till the third quarter of this fiscal year, going slow in terms of increasing the policy rate would have affected expectations. Further, the real policy rate is still deeply negative and it’s sensible to make the correction as soon as possible.
 

While the policy action last week pushed the repo rate above the pre-pandemic level of 5.15 per cent, rate decisions from here on will become somewhat trickier for the MPC. Although the committee has not changed its inflation forecast for the fiscal year, it expects the rate to moderate to 5.8 per cent in the fourth quarter, and further to 5 per cent in the first quarter of 2023-24. The inflation outlook, to be fair, remains uncertain and outcomes would depend on a variety of factors. Although global commodity prices have come down in recent weeks, the ongoing Ukraine war continues to pose risks to energy prices. A sudden decline in gas supply to Europe, for instance, could again push up global energy prices. Sustained higher global inflation would also remain a risk, while higher than expected policy tightening in advanced economies could lead to an extended period of currency market volatility with implications for inflation outcomes in India.

Besides international and domestic risks, such as the progress of the monsoon, policy decisions over the coming months would also depend on the expected natural rate of interest, or the appropriate real policy rate. A recent research article by economists at the RBI noted that the natural rate might have moderated after the pandemic, and estimated it to be at 0.8 to 1 per cent in the third quarter of 2021-22. Since the rate is difficult to determine, particularly in times of heightened uncertainty, assuming the RBI estimates hold, the policy rate would need to go up to a level above 6 per cent by the first quarter of the next fiscal year. The MPC, thus, would need to determine how quickly it intends to reach that level. The decision would clearly depend on how inflation conditions evolve till the next meeting of the committee. An upside surprise, which remains a possibility, would require another 50 basis point hike in September. Moderation in inflationary pressure, on the other hand, would allow the MPC to go for a lower rate hike with clear guidance as to what it intends to attain over the coming quarters.