Macroeconomic adjustment

Risks for growth and asset prices have increased

After an off-cycle meeting in May, leading to an increase in the policy repo rate by 40 basis points, the outcome of the Monetary Policy Committee’s (MPC’s) June meeting on Wednesday did not surprise financial markets. The rate-setting committee of the Reserve Bank of India (RBI) unanimously decided to increase the policy repo rate by 50 basis points to 4.9 per cent. The standing deposit facility rate and the marginal standing facility rate were adjusted accordingly. Financial markets were relieved that the policy rate hike was not accompanied by another increase in the cash reserve ratio. But this relief is unlikely to last very long. The RBI governor’s statement and the resolution of the MPC clearly suggest that the policy rate will need to be increased materially, along with the removal of excess liquidity.

In terms of liquidity conditions and the future rate trajectory, there are two important takeaways worth noting here. First, the MPC has not used the word “accommodative” in its stance and is now focused on the withdrawal of accommodation. Its use was making the central bank’s stance confusing. Second, the MPC has revised its inflation projection by 100 basis points. It now expects the retail inflation rate to average 6.7 per cent this fiscal year. Notably, the committee expects the inflation rate to remain above the tolerance band in the first three quarters of FY23. According to the law, this would be treated as a failure to attain the target. Following the procedure mandated by the law in such a situation in terms of providing reasons for the failure, along with the proposed action, could put significant pressure on the central bank and lead to a faster increase in the policy rate. Besides, several economists are projecting the inflation rate to remain above the RBI’s revised projection, which could further push up interest rates.

A continued increase in the policy rate will push up lending rates. In fact, the increase in market interest rates could be higher than the increase in the policy rate because the withdrawal of liquidity will also affect the cost of money. Although the level of liquidity in the system has come down, it is still high and the target market rate is running significantly below the policy rate. Higher domestic interest rates, along with negative spillovers from the global economy, such as slowing global growth, higher commodity prices, and tightening financial conditions, would affect growth prospects for the Indian economy. The RBI nevertheless has retained its growth forecast at 7.2 per cent for FY23. Capacity utilisation has improved, which could lead to some fresh investment, and the fact that both corporate and bank balance sheets have improved would also help.

However, the current year’s growth number, particularly in the first half, will be driven largely by the weak base of last year. The actual strength of the recovery will be tested in the second half of the fiscal year when growth is projected to moderate to about 4 per cent. Overall, the economy will have to make significant adjustments over the next several quarters with a comparatively unfavourable global environment, higher domestic inflation, and interest rates, which will have implications for growth and asset prices. The uncertainty is likely to continue until inflation is brought back closer to the target.