RBI Monetary Policy: MPC Seen Front-Loading Another Repo Hike, Then Being Data-Dependent

Bank of International Settlement analytics suggests that front-loading of rate hikes is more likely to result in a “soft landing” of economies. One Group of 10 central bank has explicitly asserted this while delivering unprecedented rate increases, while others have signalled this through the quantum of their respective rate hikes. The Reserve Bank of India’s own research also states that “repeated supply shocks trigger second-round effects through cost-push, expectations, exchange rate and demand channels, warranting pre-emptive monetary policy action”.

Spillovers into emerging markets from tight external financial conditions, following G-10 central banks’ actions in June and July had been significant and are expected to continue over the tightening cycle. However, markets’ expectations over the past couple of months of aggressive tightening are gradually moderating, given signs of slowing economic activity and weakening consumer confidence. Commodities and metals prices have also fallen significantly over the past couple of months.

Central banks, in various degrees, also seem to be communicating a more moderate pace of tightening. Jerome Powell, chairman of the Board of Governors of the U.S. Federal Reserve, surprised markets with unscripted remarks that the Fed Funds Rate has reached the neighbourhood of “neutral rate” and indicated that US monetary policy is hereafter likely to follow a more data-dependent approach, focused largely on inflation prints, but keeping an eye out for growth and employment. The Reserve Bank of Australia, while raising its policy rate by 50 basis points, indicated that “it is not on a pre-set path” and that future rate increases will be guided by incoming data.

IMF, its recent update on global activity, forecasts world growth to slow to 3.2% year-on-year in calendar 2022 (down 0.4 percentage points from its earlier April estimate) and thereafter to 2.9% in 2023. Particularly sharp downward revisions are forecast for U.S. activity (growth at 2.9% and 1.0%, respectively) and China (3.3% in 2022). Of larger concern for India, global trade volume (both merchandise and services) is predicted to slow to 4.1% and 3.2% in 2022 and 2023, down from 10.1% in 2021. India’s average core (i.e., non-oil and jewellery) export growth during Jun-April FY22 had been 24% YoY, which has since dropped to 9% in June 2022 and 5% in July. Services export growth had averaged 22% during the 10 months of FY22. There is concern that this will gather pace in H2 of FY23.

While a slowdown is certain – that’s the point of policy tightening anyway, to cool down heated economies – and also probably the pace of rate hikes after a couple of months, rate hike reversals are unlikely over the next year at least. The U.S. is already in a “technical recession”, with a Q2 2022 de-growth of 0.9%, following a -1.6% print for Q1. However, although some indicators of activity are showing signs of weakness (housing, some retail sales), overall activity, and particularly labour markets remain very strong. Europe, buffeted by energy shocks, is likely to slow down more quickly, which is beginning to be reflected in consumer confidence surveys. China’s economy is emerging as a significant concern, with falling potential growth levels being aggravated by inefficient regulations and sector-specific stresses.

Facing the Impossible Trinity of open economy macroeconomics, RBI’s monetary and liquidity policies in this tightening cycle have attempted an outcome requiring the least growth sacrifice for price stability, while maintaining a stable external account. With India facing very tight external financial conditions, RBI has smoothly guided the Rupee, more or less in line with a basket of Asian emerging markets currencies.

Despite a significant turnaround in the Dollar/Rupee exchange rate over the past week, the record merchandise trade deficit for July suggests that India’s current account deficit will likely remain under some stress, which will necessitate continuing with a multi-dimensional monetary policy response function, with the primary objective of price stability.

In this global backdrop, how might RBI and MPC be thinking about the forthcoming and future rate actions? Inflation, of course, remains the primary objective of the (flexible) inflation targeting mandate.

This is premised on the Indian crude basket at an average $100-105/barrel.

We expect that MPC will hike the repo rate by 35-50 bps at this review, taking it beyond the pre-pandemic 5.15% level. As with the other central banks, the hikes thereafter are likely to be more calibrated, with conventional 25 bps increases, depending on the evolving tradeoffs of a growth moderation versus price stability. With an RBI estimate of a “real natural rate” of 0.8-1.0%, and taking a one-year ahead view of monetary policy, the “neutral” rate, measured by the 3-month treasury bill, should be around 6%.

Finally, the policy rate increases will be accompanied by gradually tightening liquidity. Although system excess liquidity had dropped sharply last week to a low of Rs 45,000 crore, the actual latent liquidity (factoring in the central government’s estimated balances with RBI) might be around Rs. 3 lakh crore - 4 lakh crore, which will largely return into the system as monthly spending rises.

Aug. 2’s surplus liquidity has already reverted to over Rs 2 lakh crore. This will likely be higher than RBI’s estimate of a non-inflationary liquidity surplus threshold of Rs 1.7 lakh crore to 2.5 lakh crore. However, a steady increase in cash in circulation, based on seasonal patterns, is expected to reduce the system liquidity surplus to near zero by December 2022, if not earlier. This might require an infusion of liquidity by RBI, particularly if demand for credit from banks remains high throughout the year.

Saugata Bhattacharya is Executive Vice President and Chief Economist at Axis Bank. Views are personal.

The views expressed here are those of the author, and do not necessarily represent the views of BQ Prime or its editorial team.