RBI’s Monetary Policy: Shaktikanta Das would have to juggle between the devil and the deep blue sea

There is hardly any disagreement about the direction the repo rate will take. Repo rate is the rate at which banks borrow funds from the Reserve Bank of India (RBI), which in turn impacts their cost of funds or lending rates. The big issue is the magnitude of the rate hike in tomorrow's monetary policy outcome. Is it going to be 35 or 50 basis points?

"We expect a 50-basis point hike in the current policy and for the policy rate to gradually reach 6.0 to 6.25 per cent in the current cycle," says Sonal Badhan, economist at the Bank of Baroda. The current repo rate is 5.40 per cent. At the last three monetary policy meetings since May this year, the RBI has increased the repo rate by 140 basis points to 5.40 per cent.

"RBI MPC may be tempted to deliver a 50-basis rate hike at the upcoming policy," says Lakshmi Iyer, Chief Investment Officer (Debt) at Kotak Mahindra Asset Management Company. There is certainly a case now for front-loading interest rates by a hefty 50 basis points. "Given that the US Fed is expected to continue tightening in larger than the conventional rate increments in 2022, and hence, the dollar remaining strong, RBI will need to deploy a combination of measures to balance the trade-offs in its monetary policy objectives --- management of interest rates, the rupee and system liquidity --- which can minimise the growth sacrifice ratio even while gradually reverting the CPI inflation trajectory to near the 4 per cent target," believes Saugata Bhattacharya, Chief Economist at Axis Bank.

Let's look at the dilemma before the RBI Governor, Shaktikanta Das.

The CPI index, or retail inflation, which the RBI tracks for setting its repo rate, has gone up from 6.71 per cent in July to 7.0 per cent in August 2022. The inflation target for the MPC is 4 per cent with an upper tolerance band of 6 per cent. The RBI, however, believes that inflation will remain high at around 6.7 per cent in 2022-23. In fact, the MPC expects inflation to be above 6 per cent for the first three quarters of 2022-23. Barring transport and communications, all the other items of retail inflation are up from April this year, when headline inflation peaked at 7.79 per cent. Inflation is very sticky in items like food & beverages, clothing & furniture, fuel & light, household goods, and education segments.

"Given that a significant part of inflation in the next few months is likely to arise from food, monetary policy will also need supplemental actions from fiscal, trade, industrial, and agriculture policies in order to insulate aggregate demand to the extent possible from supply shocks," says Bhattacharya. There is another danger before the RBI, which is to maintain retail inflation below the upper band of 6 per cent for three consecutive quarters. Currently, retail inflation is above 6 per cent from January to August this year. Any failure to keep inflation below 6 per cent will necessitate a detailed report to the government outlining the reasons for the failure, corrective action, and the time period required to bring it back down to targeted level. That's another big headache for RBI and also a case for front-loading the rate hike in the current policy.

Second, the direction of US Fed rates have a significant impact on developing market monetary policy. Suman Chowdhury, Chief Analytical Officer at Acuité Ratings & Research, agrees when he says that the narrative for the upcoming MPC meeting will not just be driven by the concerns about the inflationary trajectory but also the sharply rising interest rates in the developed economies that continue to have an impact on the rupee and India’s foreign exchange reserves.

The Fed rate has gone up from 1.0 per cent in May this year to a high of 3.25 per cent in just a matter of just 5 months. The next target is 4.0 per cent by December 2022. Jerome Powell, the Fed chairman, is dead set on returning retail inflation to a targeted 2 per cent, which is currently at 8 per cent , which is a 40-year high.

Powell has often and forcefully reaffirmed his position that he will continue to fight inflation despite his concern for a recession. Interestingly, the 2 per cent average inflation target in US will be achieved only by 2024. According to projections, the Fed may reach 5.2 per cent by December 2022 and 2.6 per cent by December 2023. The Fed rate hikes encourage dollar outflows from emerging markets and back to US for higher returns. Take for instance, the US dollar index, which measures the US dollar value as against the basket of currencies, which showed a big jump from 96 in January this year to 114 level in September. The interest rate differential between India and the US is also widening from a range of 3.75 per cent to 7 per cent plus in the last decade to a much lower 3 per cent.

The US fed rate hikes are already wreaking havoc on the currency markets. The rupee has depreciated by about 8 per cent to 82 levels against the US dollar despite the RBI selling dollars in the market. There are also limitations on the RBI to use its foreign exchange reserves to protect the rupee's value. In the last year, the foreign exchange reserves have fallen from $640 billion to $540 billion. If we take FY22 imports of $613 billion, i.e. $51 billion monthly, the forex reserves of $540 billion will cover imports for just 10 months, down from 12 to 13 months earlier. "Declining forex reserves means a lower import cover ratio and also a reduced cover for short-term loans due for redemption," says a market player.

There are already concerns in the minds of investors on the rising current account deficit as the dollar inflows via FDI, foreign portfolio investments, private equity and venture capital funds are expected to decline in the near future. In 2021-22, the trade deficit was $191 billion and the CAD as a per cent of GDP was 1.2 per cent. CAD is now expected to jump to 3 per cent of GDP in 2022-23. In the first four months of 2022-23, the CAD is already at $97 billion. The net dollar outflows from FPI are to the tune of Rs 1.62 lakh crore in debt and equity markets for the calendar year 2022. FPIs were net buyers in the financial markets over the last three years, with net inflows of nearly Rs 3 lakh crore. The dollar inflows earlier were on the back of near-zero fed rates and also quantitative easing. There is already a reversal of flows because of the rupee's depreciation against the US dollar.

Big question, therefore, is should the RBI give a strong signal to the market by hiking rates by 50 basis points or more?

Many experts point out that the government should take action on the import or custom duties front to discourage certain imports like gold, for example. The RBI also has many tools to encourage dollar inflows into the country, which will protect the value of the rupee. In the recent past, RBI had lifted the interest rate cap on NRE and FCNR(B) deposits, gave more choices to foreign investors to invest in Indian debt and also doubled the ECB limit for corporate sector.

Finally, the frontloading of rates will also have some impact on the growth. The RBI has earlier projected the GDP to be at 7.2 per cent for 2022-23, but it is likely to be revised as the actual GDP of 13.5 per cent in first quarter (April-June) of 2022-23 is way below the RBI's projected 16.2 per cent for the same quarter. "We could also see some small downward tweaks to GDP growth forecasts with CPI forecasts likely to remain unchanged," says Iyer of Kotak Mahindra AMC.

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