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An orderly exit

Saugata Bhattacharya writes: RBI, government must act in coordination during an economically challenging period

Going forward, more conventional increases of 25 basis points are likely. Second, RBI’s research suggests that the ‘real natural rate’ — the rate at which policy is neither loose nor tight — is 0.8-1 per cent. (Reuters)

In its latest meeting, the members of the monetary policy committee voted unanimously to increase the policy repo rate by 50 basis points to 5.4 per cent. This was in line with the RBI’s views on the need for pre-emptive action and a front loading of rate hikes to quell the second-order effects in the face of repeated supply shocks. The repo rate was 5.15 per cent in February 2020. So, in effect, the RBI’s policy has not only been normalised, but has actually tightened compared to the pre-pandemic level. Even the lower bound of the rate corridor, the Standing Deposit Facility (SDF) rate, at 5.25 per cent is now above the pre-pandemic repo rate.

While the policy rate hike was widely expected, more anticipated were the MPC and the RBI Governor’s forward guidance on the trajectory of policy — on both monetary policy and liquidity instruments. So, how do we see monetary policy evolve over the rest of the year and beyond?

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The first signal was on the stance of policy. Given the front loading of rate hikes, retaining the policy stance rather than shifting to “neutral” was a bit surprising. The reasons for one MPC member differing on this will become clearer after the minutes of the meeting are released. However, reading between the lines, this retention of stance might be interpreted as being a bit more hawkish than “neutral”, which implies that rates might be both increased or cut, depending on economic conditions. This might have been construed as a signal that rates had risen to a “neutral” point. The governor reinforced this by emphasising that with the growth momentum expected to be resilient, monetary policy should “persevere further in its stance … to ensure inflation moves closer to the target of 4 per cent”. Hence, further tightening is on the cards.

But by how much? First, now that policy is largely normalised, the pace of tightening is likely to moderate. The urgency of aggressive rate hikes and tightening of liquidity has somewhat moderated, although risks remain. Going forward, more conventional increases of 25 basis points are likely. Second, RBI’s research suggests that the “real natural rate” — the rate at which policy is neither loose nor tight – is 0.8-1 per cent. This operative interest rate is usually the three-month T-bill rate, which in “normal” times averages 10-15 basis points above the repo rate. Considering that monetary policy is calibrated over a one-year horizon and using the RBI’s inflation forecast of 5 per cent for the first quarter of 2023-24, the “natural” repo rate will be around 5.85 per cent. Considering the tightening phase of the current cycle, the terminal repo rate — the level at which monetary policy will pause — is likely to be around 6.25 per cent.

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But all this will depend on evolving inflation and growth conditions. The RBI’s growth projection for 2022-23 has been retained at 7.2 per cent, with growth frontloaded in the first half. CPI inflation is still forecast to average 6.7 per cent.

Inflationary pressures are likely to wane in the second half of 2022-23, particularly if the recent drop in industrial metals prices persists over the next few months. IIM Ahmedabad’s Business Inflation Expectations Survey (BIES) shows cost inflation expectations, while still high, are moderating. A more or less normal monsoon might help in keeping food prices stable. However, risks remain. Demand for consumption goods seems to be resilient, enabling some further pass-through of input costs. Activity in domestic services sectors has also improved, largely as pent-up demand which confers greater pricing power. Combine this with tight labour markets and rising wage costs in some tech-oriented sectors.

Consequently, domestic growth prospects seem robust. High frequency indicators of economic activity have recovered after some weakness in June. In addition to resilient demand, there is evidence of a closing of the “output gap”. The RBI’s survey shows manufacturing capacity utilisation at 75.3 per cent in the fourth quarter of 2021-22 (relative to its long-term average of 73.7 per cent); this is likely to have moved up even higher thereafter.


However, global growth and trade are forecast to significantly slow down in 2022 and 2023, largely due to aggressive tightening by G-10 central banks and a slowdown in China. The IMF predicts global trade volume (both merchandise and services) to slow to 4.1 per cent and 3.2 per cent in 2022 and 2023, down from 10.1 per cent in 2021.

With world growth and trade flows moderating, along with a drop in commodities prices, India’s export growth is likely to be lower than last year. The current account deficit remains a concern. Although India’s external balance sheet remains quite robust, as is evident from various balance of payments and debt metrics, and reportedly low unhedged foreign currency borrowings continued tightening by global central banks, particularly the US Federal Reserve over the rest of 2022, will keep India’s external financial conditions tight and likely limit portfolio capital flows. However, there are some signs emanating from these central banks that the hitherto front-loaded tightening might moderate going forward. This will take some pressure off the rupee, though, exchange rate volatility management will remain a part of the overall monetary policy management framework.

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As part of this framework, during the earlier phase of policy normalisation and the recent tightening, liquidity management has played an important role in influencing short-term money market interest rates. The current latent surplus liquidity — the existing funds with banks and the Union government’s unspent revenues parked with RBI — is over Rs 5 lakh crore. While the extent of liquidity surplus during the Covid months has come down, these levels are still much higher than RBI estimates of non-inflationary levels of surplus, which is around Rs 1.8-2.4 lakh crore. We do expect that this will gradually fall with cash withdrawals and some potential RBI dollar sales in the coming months.

The central bank, in coordination with the government, has ensured an orderly evolution of economic conditions during a very complex and challenging environment. The exit process now will also need the same adroit use of policy instruments.

The writer is Executive Vice President and Chief Economist, Axis Bank. Views are personal

First published on: 08-08-2022 at 03:45:36 am
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