Friday, Feb 03, 2023

ExplainSpeaking | What the RBI will do this week and why

Despite growing at 6.3%, data shows that India's GDP growth momentum is losing momentum even as inflation, although moderating from the recent highs, remains uncomfortably high and sticky.

Not wanting to worsen the ongoing domestic slowdown is one reason why the RBI may not raise interest rates too rapidly from here on. (File)

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Dear Readers,

As you read this, the six-member Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI) will be assembling to deliberate India’s monetary policy stance over the next two days. The results will be known on December 7.

Why should you care?

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Because the MPC has the power to affect your monthly EMIs. If the MPC decides to raise something called the repo rate, you might have to shell out more for that car or home loan that you pay each month. That’s because the repo rate is the interest rate that the RBI charges banks when it lends money to them. As the repo rate goes up, banks are forced to charge a higher interest rate from you.

If you have been paying attention to what the RBI has been doing, you would know that the MPC has already raised the repo rate by almost two percentage points since May.

Why is the RBI raising the repo rate?

Because the inflation rate has been staying way above the comfortable zone.

By law, the RBI is supposed to ensure that the inflation rate is at 4%. In other words, the general price level rise by 4% over one full year. The RBI has the leeway to allow the inflation rate to rise by up to 6% in any particular month but if it stays above 6% for too long — say three quarters (9 months) then the RBI has to explain to the Indian Parliament why it failed in containing inflation. At present, RBI is in the dock for this reason because inflation has stayed above 6% since the start of the 2022 calendar year.

How does raising interest rates contain inflation?

Simply put, higher interest rates will do two things.


One, it will incentivise you to keep the money that you already have in your bank account (or in whatever saving instrument you use). That’s because you now would earn that much more by doing so.

Two, higher interest rates will actively disincentivise you from borrowing new loan money and use them to either buy new things or invest in new business ventures. That’s because you will now be required to shell out a higher interest rate on your loans.

The combined effect of these impulses will be to slow down economic activity in the Indian economy. As the demand for things falls, the inflation rate too will subside.

But isn’t inflation already moderating?


That’s true. Prices of crude oil and several other commodities that India imports have been falling, and in the process, the inflation rate is moderating and expected to moderate further. For instance, the inflation rate decelerated sharply from 7.4% in September to 6.7% in October.

But even then, inflation is above the 6% mark.

Moreover, while food and fuel price inflation is expected to moderate significantly in the coming days, a long period of high inflation has meant that non-food and non-fuel inflation — technically called core inflation — has become quite high. In fact, core inflation itself is above 6%.

Charts 1 and 2, both sourced from Nomura Research, provide the nature of the challenge when it comes to inflation in India. Simply put, while headline inflation is moderating, all the underlying measures of inflation are proving to be persistently high.

Chart 1: Headline inflation is moderating, but all the underlying measures of inflation are proving to be persistently high.

For instance, Chart 2 shows:

> core inflation (headline inflation minus the inflation in food & beverages and fuel), and


> super-core inflation (core inflation after further removing the inflation in the prices of petrol, diesel, gold, and silver) and

> 20% trimmed mean (which excludes 20% each of the highest and lowest retail inflation components every month)

Chart 2: Headline inflation is moderating, but all the underlying measures of inflation are proving to be persistently high.

All these metrics try to ascertain what is happening to the general price level in the economy if one were to remove the commodities that experience the most volatility in their prices.

As the data shows, such underlying measures of inflation suggest that while headline inflation may be moderating, it will take a while before the price rise witnesses a decline in a broad-based manner.”


So, what does this mean? Will RBI continue to raise interest rates?

Yes. Most experts expect that RBI’s MPC will see these underlying trends and come to the conclusion that it is too soon to declare victory over inflation.

As such, the RBI will be forced — possibly it will not be a unanimous decision by the MPC — to raise the interest rate further, albeit by a slightly smaller amount — say 35 basis points (or 0.35 percentage points) — than what it has been raising by in the previous few meetings (50 basis points or 0.50 percentage points).

How will this impact India’s economic growth?

In one word: negatively.

In fact, the key takeaway from the latest data (released last week) for the gross domestic product (GDP) in the July-September quarter is that India is already facing a slowdown.

But at 6.3%, didn’t India grow at one of the fastest rates among major economies?

That’s true. India’s GDP growth rate was one of the fastest in the global context. It is true that when compared to the other big economies of the world, India appears to be growing fast. For instance, the four economies bigger in size than India — the US, China, Japan and Germany — are either facing a recession or their growth is stalling or they are struggling to grow.

But two things should be remembered here.

One, each of these countries is considerably richer than India when one looks at per capita incomes. This implies that these economies don’t have to grow at the same rate as India does. India’s requirement for growth — think of a required run rate in a cricket match when one is chasing a target to win — is much higher than the requirement of the richer countries.

Two, India is fast losing its growth momentum.

What’s the proof that India is losing its growth momentum?

The Indian Express carried a preliminary analysis of the second quarter GDP data. You can read it here.

Table 1 provides some numbers for reference.

Table 1 | GDP: Engines of India’s economic growth

Here are some key takeaways from the GDP data.

1: While the nominal GDP — that is GDP calculated in current prices — grew by 16.2% in the second quarter, the real GDP (that is, the GDP when the effect of inflation in prices was taken away) grew by just 6.3%. The remaining 9.9% growth was due to the higher prices in the economy.

2: The momentum of this real GDP growth has slowed down since March. Look at Chart 3, sourced from HSBC Global Research. About the Q2 GDP growth, the HSBC note states: ”Though this is better than the 4% growth in June (which stood out as a blip in the GDP series for the sudden unexplained contraction in a few sectors), it is still weaker than the strong 10% growth in March (2022 versus 2019). As such, it doesn’t seem that GDP is gaining momentum”.

Chart 3 shows the momentum of real GDP growth has slowed down since March

3: Private consumption, which was the main driver of India’s GDP growth, contributing the most by growing almost 10%, was largely satisfied by imports. “It is worth noting that the bulk of the private consumption goods seem to be imported rather than domestically produced,” states HSBC (see Chart 4).

Chart 4 shows that private consumption, which was the main driver of India’s GDP growth, was largely satisfied by imports

4: Investment expenditures, the second biggest engine of growth, which grew by over 10%, too, had an oddity about it. According to HSBC’s analysis, “Capital formation seems to be driven mainly by lumped up replacement capex (capital expenditure), which could eventually run its course” (see Chart 5).

Chart 3: Private sector capex is largely replacement in nature

5: The net exports (that is, exports minus imports) are typically negative. As such, growth in this segment is a drag on the GDP. With the global slowdown, India’s exports, which have already started contracting, will likely continue to struggle (See Chart 6).

Chart 6 shows that the net exports (that is, exports minus imports) are typically negative.

6: The final engine, the government’s consumption expenditure, actually contracted. In fact, it is now down 20% from where it was pre-Covid (see Table 1 above). With the Union Budget in the offing, fiscal consolidation concerns are likely to mean that government consumption expenditure may not grow in a hurry.

It is for these reasons that HSBC believes India’s GDP growth “will soften” in the second half of the current financial year (i.e. September to March 2023). It expects the full-year growth to be 6.8% — a tad less than the RBI and the government’s expectation of 7%.

HSBC is not alone. According to Nomura researchers, “India’s growth rate cycle has peaked and a broad-based slowdown is underway”. And while Nomura believes India will grow by 7% this financial year (FY23), it projects a rather measly 5.2% for the next financial year (2023-23), which is crucial because it would be the last year leading up to the next general elections in India.

Crisil, another leading rating agency, too, expects a growth slowdown.

“…while domestic demand has stayed relatively resilient so far, it would be tested next year by weakening industrial activity. It will feel the pressure from increasing transmission of interest rate hikes to consumers as well, and as the catch-up in contact-based services fades. Also, rural income prospects remain dependent on the vagaries of the weather. Therefore, the increasing frequency of extreme weather events remain a key monitorable. While lowering demand for Mahatma Gandhi National Rural Employment Guarantee Act jobs is an encouraging sign for the rural economy from a job perspective, depressed wages are a matter of concern for rural demand,” states its recent note on GDP.

Why does a domestic slowdown matter? How does that impact RBI’s decision-making?

More than ever, India needs a robust domestic economy at a time when the global cues are negative. A domestic slowdown makes matters more tricky for policymakers.

For instance, the RBI may be tempted to abandon its primary focus on inflation control (and, as a result, go slow on interest rate hikes) if it thinks domestic growth is likely to slow down considerably.

In fact, it was the fear of risking India’s economic recovery that made the RBI fall behind the curve in its task to contain inflation in the first place. Not wanting to worsen the ongoing domestic slowdown is one more reason why the RBI may not raise interest rates too rapidly from here on.

Should the RBI prioritise crushing inflation first by continuing to raise interest rates or should it shift its focus back to boosting growth?

Share your views and queries at

Until next week,


First published on: 05-12-2022 at 09:25 IST
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