6 min readApr 7, 2023 09:39 AM IST
First published on: Apr 6, 2023 at 07:44 PM IST
The Reserve Bank of India (RBI) has decided to not increase the repo rate amid continuing hikes by important central banks such as the US Federal Reserve (Fed) and European Central Bank (ECB), and domestic inflation concerns. Given that Mint Road feels money market rates have effectively risen more than the 250-basis-point yank in the repo rate since May 2022, it decided to pause and assess the impact of rate hikes.
But if incoming data point to rising inflation risks, Thursday’s decision could prove to be only a pause in the rate hiking cycle. Options remain open since there is no change in the stance of the withdrawal of accommodation. To be sure, monetary policy tradeoffs have become sharper and choices difficult amid the banking stress that started with the failure of Silicon Valley Bank. Inflation too hasn’t been reined in yet despite steep rate hikes on both sides of the Atlantic and the US banking sector tumult hasn’t swayed the Fed.
But tightening financial conditions in the US amid the banking stress will create a downside to growth and reduce the need for the Fed to hike the rate to control inflation. The market and Fed’s communication seem at odds on how quickly that will happen. The Fed dot plot hints at another rate hike and a higher-for-longer rate scenario after that, whereas markets are pricing in an end to the rate hike and quicker rate cut.
That said, a thawing of rate hike expectations from the Fed does take some pressure off the central banks in emerging countries including India.
But the key reason behind the MPC decision on Thursday is the expectation of a decline in inflation — driven by a healthy rabi crop, normal monsoon, moderating international commodity prices and the impact of rate hikes — to 5.2 per cent in the current fiscal. It acknowledged the upside risks and stated its readiness to fight any unexpected rise in inflation.
In our base case, we expect consumer inflation to cool to 5 per cent this fiscal from an estimated 6.8 per cent in the last, for three reasons.
One, we expect fuel inflation to reduce to 3 per cent from a high of over 10 per cent in the current fiscal because some easing of crude oil prices is likely as global growth slows down. We have assumed crude at $85 per barrel.
Two, slowing domestic growth will ease core inflation from very sticky levels of over 6 per cent last fiscal 2023 to 5.5 per cent in the current one. The decline in core inflation will be limited as input cost pressures have not dissipated. To protect their margins, firms will continue to pass on input costs to end-consumer. Services inflation will also continue to exert pressure as the rotation of consumption demand from goods to services continues.
Three, food inflation, which has a high weightage in the Consumer Price Index and has driven headline inflation in the past, is projected to moderate to slightly below 5 per cent, assuming a normal monsoon. However, food inflation has always been volatile and carries upside risks largely because of climate-related factors affecting agriculture output and prices. The ongoing freak weather events continue to threaten rabi cereal, fruit and vegetable production. After three years of La Nina, 2023 is expected to see El Niño play out. The Indian Meteorological Department will issue clear guidance later this month. Over the past two decades, we have observed a very close association between El Niño and scanty rains in the monsoon season. So, fingers crossed on that.
Government intervention in the wheat market has moderated wheat inflation. Given the increasing frequency and intensity of freak weather events, the role of government policy in addressing supply shocks to inflation will gain prominence.
We expect GDP growth to slow to 6 per cent from 7 per cent this fiscal as slowing global growth, domestic interest rates, and messy geopolitics bite. Slowing global growth will be net negative for our exports for three reasons.
One, the impact of the growth slowdown in the US and Europe (whose combined GDP is twice that of China) is deeper than the recovery in China.
Two, India’s exports to the US and Europe are more than to China by a factor of six.
Three, our growing dependence on commodity exports (petroleum products and steel) makes us more vulnerable to global growth volatility. Though some of the newer and fast-growing export categories such as electronic items, together with resilient services exports, offer some cushion, it is not enough to offset the impact of global headwinds. Fiscal 2024 will, therefore, test the resilience of India’s domestic demand amid rising interest rates.
Central banks raise interest rates to tame inflation and high rates work their way towards this goal by first slowing the economy. A combination of 250 bps cumulative rate hike since May 2022 and tightening of liquidity have pushed the nominal lending rates above pre-pandemic levels, with some more transmission left. As interest rate movements impact the economy with a lag, the peak impact will play out through this fiscal.
And finally, geopolitical tensions imply India will have to reckon with volatility in crude and commodity prices. We expect crude prices to remain around $85 per barrel in 2023.
The good news on the external front is that India’s external vulnerability is expected to decline with a narrower current account deficit (CAD) and modest short-term external debt. We expect the CAD to narrow to 2 per cent of GDP this fiscal from an estimated 2.5 per cent last fiscal.
The not-so-good news is the banking turmoil playing out amid interest rate hikes by important central banks and elevated debt levels. This has tightened financial conditions in the US and increased financial sector fragility and risk of volatility in capital flows to emerging markets. In such a situation, financing of CAD will remain a key monitorable.
The writer is Chief Economist, CRISIL Limited
The key reason behind the MPC decision on Thursday is the expectation of a decline in inflation -- driven by a healthy rabi crop, normal monsoon, moderating international commodity prices and the impact of rate hikes -- to 5.2 per cent in the current fiscal. (File) 
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