On May 4, the Reserve Bank of India (RBI) decided to raise the benchmark interest rate by 0.4 percentage points to 4.4%. Over the past few months, there has been a growing clamour to raise rates, mixed with anxiety over retail inflation exceeding the central bank’s tolerance limit of 6% for three months running. The surprise to the markets was in the timing of RBI’s move, via an off-cycle meeting of the Monetary Policy Committee (MPC). In a discussion moderated by K. Bharat Kumar, Shubhada Rao and U.R. Bhat discuss whether the RBI delayed the rate hike. Edited excerpts:
Should the RBI have acted on interest rates much earlier instead of waiting till retail inflation breached 6%? After all, its mandate is to target 4% inflation. Only the tolerance limit is plus or minus 2%.
Shubhada Rao: It is important to understand the context in which most central banks have behaved the way they have these past two years. It’s been a tightrope walk between growth and inflation. We have been going through an ‘abnormal’ period that started with the onset of COVID-19, followed by the Russia-Ukraine conflict. Since March 2020, central banks globally did everything they could to support growth. As central bank balance sheets expanded, interest rates dropped with a view to support growth via financial conditions that were made ultra-easy. However, the concomitant side effect of COVID-19 was also the supply shocks across the globe, which started to feed inflationary pressures. Commodity prices began rising, causing overall pressure on input costs. But at the same time, growth had been faltering. So, naturally, policymakers were leaning more towards supporting growth. However, at some point, inflation began to bite.
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In the U.S., for instance, the Fed had actually been saying that inflation was transitory, whereas markets believed there was a more structural nature to inflation. Likewise in India, we had begun to see inflation pressures building up, markets had begun to worry more about inflation. There was an expectation in the market that demand conditions would improve from the COVID-19 years, which they did. The Purchasing Managers’ Index has begun to show consistent expansion, both for manufacturing and services, in recent times. Services have bounced back even more strongly, given demand recovery. Obviously, rising input costs had begun to now manifest in the pricing power getting back to the manufacturers, and so, a pass-through to consumers was quicker than anticipated. The war in Europe and China’s strict lockdowns hit supplies and logistics, and supply chains have become further disrupted. We have had a perfect storm where growth has been subdued, and inflation has been dramatically rising.
Did the RBI wait for too long? Perhaps. February would have been the policy time when the RBI could have articulated its concerns on not just the headline Price Index, but more on the core inflation as the economic monitor, which reflects more of your underlying demand conditions.
What moved the needle was the war. It would have been premature to raise rates last year because we were still grappling with growth troubles. The RBI did have the cushion up to 6% of inflation, [which has been provided] for abnormal conditions such as what we have seen these past two years. As inflation has threatened to remain consistently above 6%, as per mandate, it was imperative that the RBI’s focus shift back to reining in inflation. The lower bound of the rate transited from reverse repo to standing deposit facility. So, yes, February perhaps was the time when the commentary could have been more guarded and more [along] sounding off the markets that we need to be vigilant on inflation.
U.R. Bhat: From an investment practitioner’s viewpoint, economics is not an exact science. So, you can’t really have a perfect model, where if inflation goes above 6%, you immediately hike interest rates, because the 2-6% range is just an indicator. Also, one has to consider the RBI’s own view on the causes of inflation. It might have waited to see if the war would stop or if oil prices would come down dramatically. So, it can’t be seen rushing to raise rates and if something dramatic happens, to lower them soon after. If the practice of monetary policy is as simple as creating a model, an algorithm can do a better job than a central banker. There is a lot of judgment and subjectivity that goes in. This is as good a time as any to raise rates.
But looking at it holistically, I am not sure if it was appropriate for a central bank to call an off-cycle meeting and hike interest rates; I don’t think anything would have happened if it had waited before it could take up the issue in the next MPC meeting. There must always be an orderly unwinding of the quantitative easing or normalising of the interest rate cycle, because you have to give enough indications to the market about what is coming. Markets are very good at interpreting data. So, a central bank should always give some indication about what is actually bothering them, what parameters are important for them to take a decision either way, so that the market can actually take a view on this and feed that information to prices. When there is sudden change without notice, the market goes into a tailspin. That is probably what happened last week.
Also, is the interest rate hike actually a great way of controlling inflation? If inflation is largely because of problems with the supply chain, that has to be addressed. Also, the transmission mechanism is probably not all that good; because if you really see bank balance sheets, probably more than 75% of the assets are loans. Quite a lot of these are based on T-bills or external benchmark-related rates. Whether the RBI raises repo rate or not, the market has already decided that an interest rate increase is warranted, because that is how they have been trading. All these notes linked to external benchmarks were already getting repriced. So, interest rates in the market are determined by the market forces, not by fiat.
If the repo rate action itself has little impact, what else should the RBI be doing to rein in inflation?
Shubhada Rao: It’s important too that the repo rate, which is typically a signalling rate, should indicate that underlying risks of inflation are real and are going to be more likely durable. An interest rate hike is a necessary but not sufficient condition. That has to come through managing liquidity. By end-April, we were already sitting on a surplus of ₹6.5 lakh crore. Raising the Cash Reserve Ratio (CRR) for banks by 50 points will impound ₹87,000 crore starting May 21. We believe that the RBI is not going to stop with just one CRR hike. A combination of available liquidity in the system alongside a benchmark rate sends a more comprehensive signal to the market on forthcoming tighter financial conditions, which will help moderate demand. There will be a sacrifice on output. We believe that another CRR hike is in the offing, maybe as early as in the June policy review. The surplus would come down to about ₹2 lakh crore by the end of FY23.
We are already looking at coal shortages, with an eventual impact on power tariffs; we are likely to see an impact on minimum support prices, which are calculated on the basis of input costs; India needs to watch the crude basket more closely. Food costs are set to harden despite our having adequate food grains, given the global escalation in food prices because of the war.
We, as a research unit, are forecasting inflation in the 6.1-6.3% band, so about 6.2% average inflation for FY23, which is still higher than the revised inflation number of 5.7% that the RBI presented in April. In the June policy, the RBI will likely revise that further up. So, there is going to be a sacrifice on growth very clearly. But between inflation and growth, the RBI would most certainly now lean towards inflation, because it is a very inequitable tax on the less privileged.
What can the government do to make it easier? Reports say the RBI feels isolated in its battle against inflation.
Shubhada Rao: What the government could do, perhaps to the extent possible, is lower the excise on fuel further, which will help alleviate price pressures from headline fuel costs. Of course, the cost to the exchequer is fairly significant, because even if there is a 5% gap in excise, it has an impact on the government balance sheet to the extent of ₹60,000-70,000 crore. So, it will have to be weighed very carefully. Also, the Centre will have to optimise between revenue expenditure and capital expenditure. I think the Finance Minister did indicate that they are going to maintain the momentum on infrastructure spending. And while we could see some growth getting sacrificed in FY23, the medium term, i.e. over a couple of years beyond FY23, could look better. The government has done exceedingly well through some of its policy initiatives during the COVID-19 years by adding significant thrust to domestic manufacturing in the form of Production-Linked Incentives for about 14-15 sectors more actively. If not in FY23, we will see some of these supply constraints getting addressed starting FY24.
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U.R. Bhat: Given that easing supply challenges could help cool inflation, the government has got to act. The RBI can only use tools such as CRR, Statutory Liquidity Ratio, repo, etc. But tackling supply side issues is outside its domain. Of course, nobody can really take a call on which way the war will go or whether we will have a repeat of the past with COVID-19. But to the extent possible, where there are issues about transportation, container availability and the like, the government has to do its bit. It also has a duty to ensure that the growth momentum doesn’t falter. The government will have to continue to spend till the private sector starts investing.
Having said that, the government too has been trying to foster an environment of growth. The Budget had huge allocations for infra spending. That has a huge multiplier effect on the economy. The export thrust also has started showing up. If you see the export growth and GST collections, we’re doing pretty well.
But the big concern is that we now have negative real interest rates for savers. The anaemic growth in bank deposits is probably because of that. With negative real interest rates, savers will shift to the markets, or gold or real estate. I think more than two-thirds of the volumes in the equity market is from retail investors. Further, the rupee is in danger of declining further against the dollar. With the U.S. Fed also increasing rates, we will have to keep up the rate differential to help stem outflow of dollars.
The repo rate hike and such tools are effective only when you have credit growth in the high teens or 20%-plus. But with 9-10%, efficacy in tweaking benchmark rates may not be all that much.
How do you trigger healthy credit growth?
U.R. Bhat: If we want GDP growth of 7% and if there is 6% inflation, that means 13% nominal GDP growth. This needs to be financed. So, the banking system has to be able to grow its credit book quite dramatically to be able to reach these numbers. Because of the huge demand shock, private sector investments have taken a backseat.
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As the economy gradually returns to normal, the private sector will start investing in new capacities. The biggest enabler for new investments to happen is the government’s investment in infrastructure. When you have good roads, port capacity, good railway capacity, and good telecommunications, people will start investing and generate demand in phases. These will happen. We have been through such phases very many times in the past. If you look at the GST collections and export numbers, things are not really bad. We are getting there.
U.R. Bhat is co-founder and Director of Alphaniti Fintech; Shubhada Rao is founder, QuantEco Research