Eye on target: Fears of high inflation prompted RBI's off-cycle meeting

Near 7 per cent retail inflation in March and expectations of similar prints in April – and probably the entire April-June quarter – necessitated the off-cycle meeting of the monetary policy committee (MPC) members as they realised the urgency to act fast or face the grim prospect of failing to fulfil their mandate.

In a surprise move, the MPC increased the repo rate by 40 basis points (bps) to 4.4 per cent on Wednesday. The cash reserve ratio was hiked by the RBI by 50 bps to 4.5 per cent.

The main objective of the MPC is to target 4 per cent consumer price inflation with a variation of 2 per cent on either side. A situation when average inflation is more than the upper tolerance level or less than the lower tolerance level of the inflation target for any three consecutive quarters is considered failure on part of the MPC.

Retail inflation, the main yardstick of the MPC for policy making, was above 6 per cent in the January-March quarter, with the March CPI figure at 6.95 per cent.

“The March CPI numbers were way above expectations, which were little less than 6.5 per cent. That surprised everyone, including the RBI and professional forecasters,” said a source.

Sources indicate that the April numbers were expected to stay much above the RBI’s upper tolerance limit.

“If the RBI did not go for an off-cycle, then it had only two meetings – June and August to react. It was important for the MPC to get enough time to space out policy actions,” the source said.

In the April meeting, the MPC had said the focus would be reversal of ‘accommodation’ – which means reversing the rate cuts – which was 115 bps during the pandemic. Increasing 115 bps in two policies needed sharp rate hikes – something which was avoided with the off-cycle meeting.

The RBI governor, during his address while announcing the rate hike on Wednesday, said, “…the decision of the MPC today to raise the policy repo rate by 40 bps to 4.40 per cent may be seen as a reversal of the rate action of May 22, 2020 in keeping with the announced stance of withdrawal of accommodation set out in April 2022.” The central bank prepared the markets for an eventual rate hike by announcing that the focus will be withdrawal of the accommodation.

Following the release of the March numbers, RBI researchers started tracking several indicators on prices – like ministry of consumer affairs data, prices of local wholesale markets, as well as that of vegetable delivery apps on a daily basis. All these suggested that prices were going up, more than what was expected, which would add momentum to the April data.

“An analysis of March CPI number showed 75 per cent of the food price rise was due to the war,” said the source, referring to the Russian invasion of Ukraine that choked supply. Indonesia banning palm oil exports was yet another blow to edible oil prices – which was something not expected. 

The March CPI numbers were released on April 12 – about a week after the MPC reviewed the monetary policy. The April policy saw RBI changing its priority to address inflation – from growth – which was its priority since the Covid-19 pandemic broke out two years back. The MPC members probably saw what was coming, as the inflation forecast for FY23 was revised sharply to 5.7 per cent, from 4.5 per cent projected in the February policy. Inflation forecast for the first quarter of FY23 was 6.3 per cent, for Q2 was 5.8 per cent.

Growth forecast was cut to 7.2 per cent, from 7.8 per cent for FY23. Both forecasts were made assuming crude oil prices at $100/bbl.

With inflation staying more than 200 bps above the repo rate than the repo rate, the real interest in the economy is negative. With a rate hike of 40 bps, the central bank has started the journey to make the real rates zero, analysts said. The journey towards zero real rate is achieved with both interest rates going up and inflation coming down.

The interest rate hike cycle also starts at a time when the government will borrow a whopping Rs 14.31 trillion. Increase in interest rates pushes up the borrowing cost for the government. One way to keep bond yields under check is to conduct open market operations by the RBI – the government’s debt manager – to infuse liquidity. However, at a time when the RBI is hiking cash reserve ratio to suck out liquidity from the banking system, OMOs to infuse liquidity would send contradictory signals, analysts said.

The 50 bps CRR hike, which will drain out Rs 87,000 crore from banks, is unlikely to result in liquidity issues as the lenders are parking over Rs 5 trillion in the standing deposit facility window. The CRR hike was required to drain out the excess liquidity as such huge liquidity would stroke inflationary pressures.