The dilemma of Shaktikanta Das: Taming inflation amid global headwinds

If there was one regulator who stoutly backed the government’s initiatives to keep the economy afloat during the worst times of the Covid-19 pandemic, it would clearly be the Reserve Bank of India (RBI). As the pandemic hit India in 2020, RBI Governor Shaktikanta Das became a figure the government and the economy looked up to for support as the central bank unveiled liquidity support measures aggressively to ensure a lockdown-hit economy did not collapse. Along with targeted liquidity support measures, RBI had opted for an ultra-accommodative stance, first reducing the repo rate—the rate at which RBI lends short-term funds to banks—by a hefty 75 basis points (bps) on March 27, 2020, and as the pandemic continued to grip the world, followed it up with another 40 bps cut on May 22 the same year. Cut to May 4, 2022, and RBI’s shock ‘off cycle’ announcement of a 40 bps hike in the repo rate, together with a 50 bps hike in the cash reserve ratio—the money banks must park with RBI as a portion of their net demand and time liabilities (NDTL)—came as a stunner for the markets. Bond markets went on a tailspin, and so did the equity markets, with the benchmark S&P BSE Sensex crashing over 1,300 points at the end of trading day.

Why were the markets caught off guard? After all, inflation had been rising, food and fuel prices had been giving sleepless nights to policymakers, and the war in Ukraine shows no signs of abating just yet. So the financial markets and the corporate sector, as economists agree, were bracing for rate hikes. I remember, many years ago during my reporting days, the then RBI Governor Bimal Jalan telling me that one of his biggest tasks as the man in charge of monetary policy was to “manage expectations” in the economy. Markets and the financial system do not like surprises. Towards that end, RBI always needs to give—and does give—signals about its stance and what its assessment is about the economy, in particular on inflation. And that’s also the very reason there is a system of announcing monetary policy statements every two months, six times a year. 

The markets had been talking of a rate hike, a kind of signal of maybe 15 bps at the minimum, even in the April policy. However, RBI did not change the repo rate then, though the central bank did explicitly warn of mounting inflationary risks even in that statement. “The February 2022 meeting of the MPC had projected a moderating path for inflation during 2022-23. Heightened geopolitical tensions since end-February have, however, upended the earlier narrative and considerably clouded the inflation outlook for the year,” RBI said in April, adding: “It may, however, be noted that given the excessive volatility in global crude oil prices since late February and the extreme uncertainty over the evolving geopolitical tensions, any projection of growth and inflation is fraught with risk, and is largely contingent upon future oil and commodity price developments.” It also said: “The situation is dynamic and fast changing and our actions have to be tailored accordingly.” These could be seen as signals that off-cycle measures may become necessary.

CRISIL Chief Economist Dharmakirti Joshi tells me that RBI’s move and timing need to be viewed in the context of the data available with the central bank. Central bank moves will always be data driven, and a lot had, indeed, changed between February and May, with the Ukraine crisis continuing, and inflation spreading from a few pockets and getting generalised. While the government would be seeking to cool down the inflation around fuel and food, RBI’s job was aimed at ensuring this did not percolate and become a generalised inflation. A CRISIL note points out that the consumer price index-linked (CPI) inflation saw a sharp rise to 7 per cent in March, 100 bps above the upper limit of the RBI’s target range of 2-6 per cent. “Since then, the drivers behind rising inflation show no signs of abating. The supply shock caused by Russia-Ukraine war has been exacerbated by China’s pandemic-driven restrictions, and Indonesia’s ban on edible oil exports. International prices remain elevated for food, energy and metal commodities, which will lead to higher food, fuel and core inflation this fiscal,” it adds. CRISIL explains that in fiscal 2021, inflationary pressures came largely from food and, to some extent, core (which excludes fuel and food). “Back then, fuel inflation was quite benign. Last fiscal, crude prices rose and became the new inflation driver. While core inflation rose as a consequence, the drop in food inflation offset this, so overall inflation was lower at 5.5 per cent compared with 6.2 per cent on-year. What makes this fiscal perturbing is, all three indicators are now firmly pointing in one direction – up.”

The blunt instrument of the CRR hike, of course, was an added attack on inflation since it sucks out money from the system almost immediately, with this 50 bps hike taking away ₹87,000 crore in one fell swoop. The ‘telegraphing’ of the actions, however, could have been better, Joshi agrees. 

Bank of Baroda Chief Economist Madan Sabnavis feels we need to be more charitable in our view on RBI’s timing, since there were multiple factors at play. He tells me ideally, a rate action could have been undertaken in the April policy, or even in June, and it would have had probably the same impact. But the May 4 rate hikes probably demonstrate that, recognising the mounting dangers around inflation, together with the continuing global headwinds, RBI was in a hurry to ensure there wasn’t a broader impact. With the US Fed and the Bank of England hiking rates, the external environment was likely to put pressure on foreign flows, and, consequently, the currency, with the continuing war being an added variable. Some RBI watchers also feel RBI may have wanted to send a clear signal that it wasn’t falling behind in its war on inflation, given the March print of 7 per cent CPI. There’s also some chatter that the LIC IPO could have played a role in delaying the rate hike.

Another element of the May 4 announcement which has confused the financial markets is the central bank’s stance. Despite announcing a 40 bps repo rate hike and a 50 bps CRR hike, Governor Das announced: “The MPC also decided unanimously to remain accommodative while focusing on withdrawal of accommodation to ensure that inflation remains within the target going forward, while supporting growth.” It is this conjunction of remaining accommodative while withdrawing accommodation which isn’t doing much for clarity for the markets.

What do the rate actions mean for business confidence? The latest print of the quarterly Business Today Business Confidence Index shows confidence at a seven-year high of 55.2 (on a scale of 100) for the fourth quarter of FY22. For the first quarter of FY23 too, confidence is high. Joshi reckons there are enough positives to ensure business confidence does not take a hit despite the rate actions and inflation. One of the big positive factors is the return of the services sector—airlines and hotels are seeing a big upturn—and other contact based services are also on the upswing. The services upswing could service as a major cushion. Besides, corporate balance sheets are getting cleaned up and larger companies would not get impacted, though small and medium enterprises (SMEs) would continue to struggle for a while, in particular those in the informal sector. Sabnavis adds that business confidence would not be rattled owing to the rate hikes since a 75-100 bps had been factored in by most in the corporate sector. Both economists tell me further rate hikes will come about, and soon, as RBI could be in a hurry to normalise things around inflation. Joshi reckons a further 75-100 bps hike in the repo rate, with hikes frontloaded given the high inflation levels, while Sabnavis reckons there will be a hike of another 50-75 bps this fiscal.

Cutting back to Governor Das. With global headwinds continuing to pose a severe threat, the governor would have to continue keeping inflation as top priority, despite the threats the economy faces on the growth front. Having weathered the Covid-19 challenge, Das will now have to pull out all stops to battle the massive threat of inflation. The financial markets will, however, be hoping for fewer ‘shocks’ like the May 4 one, and more clarity on the stance going forward.

As Das said on May 4: “As several storms hit together, our actions today are important steps to steady the ship. We remain watchful of incoming data and information to constantly reassess the situation and the outlook. We will be proactive and flexible in our approach.” The governor added: “Inflation must be tamed in order to keep the Indian economy resolute on its course to sustained and inclusive growth. The biggest contribution to overall macroeconomic and financial stability as well as sustainable growth would come from our effort to maintain price stability.” This is, perhaps, a big signal in itself.

 

The author is Editor, Business Today.