Opinion Why the MPC continues to hike interest rates

The MPC has also voted to retain the stance on “remain(ing) focused on withdrawal of accommodation to ensure that inflation remains within the target going forward, while supporting growth”, similar to its views on many previous occasions. The earlier two-member dissent against this stance continued. While we had not expected a shift to “neutral”, there was the possibility of a tweak in the language. For instance, the framing could have been, the policy is approaching “restrictive territory” or towards “a substantial removal of accommodation”. But, that was not to be.

In addition, the forward guidance communicated that “further calibrated monetary policy action is warranted to keep inflation expectations anchored (and) break the persistence of core inflation”. The missing phrase this time was the need “to contain second round effects”. This statement, for good measure, adds to the December review that “the MPC will continue to maintain a strong vigil on the inflation outlook… to ensure that it… progressively aligns with the target”. In short, there is a strong commitment to get inflation down to the 4 per cent target, albeit on a glide path, maybe in 2024-25. There is, however, not a whiff of signaling a pause while assessing the impact of the rate hikes across various channels on growth and inflation.

This article is emphasising the syntax of the statement since forward guidance, however nuanced or ambiguous, becomes crucial in judging the evolution of actions at or near the cusp of a change in the policy trajectory. Overall, monetary conditions still “remain accommodative”. This needs to be looked at in the context of the RBI’s earlier definition of accommodative which was based on a comparison of the pre-pandemic rate hike cycle in 2018 and 2019. During August 2018 to January 2019, the repo rate stood at 6.5 per cent when CPI inflation averaged 2.9 per cent, as against now when inflation has averaged 6.6 per cent over July-December 2022, though it is now falling. The rate cuts started in February 2019 when GDP growth had started decelerating. In contrast, GDP growth in the first quarter of 2023-24 is forecast to rise sharply to 7.8 per cent, up from its earlier assessment of 7.1 per cent.

Economic forecasts reinforce our view that rate hikes still have some way to go. The biggest surprise was the RBI’s 2023-24 growth forecast — a projection of 6.4 per cent is an assessment of strong economic activity. This is much higher than the analysts’ consensus of a 6 per cent growth outlook, although it is aligned with the 6-6.8 per cent forecasted in the Economic Survey, centred at 6.5 per cent.

Although, not as unexpected on the upside, even the inflation forecast of 5.3 per cent for 2023-24 is higher than the markets forecast of 5-5.1 per cent. Even more telling are the quarter-wise forecasts for 2023-24 (5 per cent in the first quarter, rising to 5.6 per cent in the fourth quarter), implying that not even one quarter will see a sub-5 per cent inflation. One reason could be a base effect — the slight reduction in the 2022-23 forecast from 6.7 per cent to 6.5 per cent. Even here, it is emphasised that this was largely due to the deflation in vegetable prices and the fall in food prices is not broadbased. “Sticky” core inflation is highlighted, with the risk that “the ongoing pass-through of input costs, especially in services, could keep (this) at elevated levels”.

So, what does this imply for monetary policy going forward?

The tone and tenor of the communication seem to severely dent the near consensus view that the repo rate at 6.5 per cent was the “terminal rate” and that the MPC would pause at this point.

Several points need to be made.

First, RBI research indicates a “neutral” real three-month treasury bill rate of 100 bps. Given a one-year ahead inflation forecast of 5.3 per cent, that translates to around 6.3 per cent (the bill rate is now 6.5 per cent). However, policy still needs to be “restrictive” given the current growth–inflation dynamics. Hence, the appropriate repo rate at this point will probably need to be at least 6.5 per cent, until there is a durable decline in inflation.

Second, domestic demand remains surprisingly resilient, even after cumulative repo rate hikes of 225 bps since early May 2022 (excluding the additional 25 bps increase yesterday). Direct tax collections remain strong, indicating, inter alia, corporate financial strength. GST collections (as well as trends in e-way bills) suggest strong economic activity. Manufacturing and Services Purchasing Managers Indexes (PMIs), although moderating, show strong order books. Manufacturing capacity utilisation was at 74.5 per cent in the second quarter of 2022-23, indicative of a closing “output gap”.

India’s external “financial conditions” are likely to remain tight and uncertain for the foreseeable future. As global growth conditions have proven to remain unexpectedly strong, the G10 central banks will probably need to keep hiking their policy rates and remain “higher for longer”, keeping markets volatile. This is evident in the renewed volatility in the rupee.

Lagging growth in deposits might become a drag on sustaining the double-digit credit growth in 2023-24. Lending rates on fresh loans had risen by 137 bps over May-December 2022, while interest rates on fresh deposits were up 213 bps. These would have risen further in January, and more post the latest rate hike. The pass-through of higher deposit rates to loans is still ongoing and this might impact credit to MSMEs. We believe that at some point in 2023-24, the RBI might have to (and should) judiciously provide some liquidity support, even while maintaining the inflation control stance.

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