Monetary policy preview: Front-loading rate hikes for macro stability

In the run-up to the Mone­tary Policy Committee (MPC) meeting, global commodity prices have retraced to almost the pre-Ukraine conflict levels and the Consumer Price Index (CPI) trajectory in India has broadly followed the expected path. While this will provide a sense of comfort to the MPC, there are again some brewing supply-side shocks on food prices that can pose upside risks to near-term inflation prints.
 

Deficient rainfall in some parts of the country is threatening prices of rice and pulses, while excess rainfall in others is causing vegetable prices, particularly toma­toes, to move up again. The trend in food prices would increase the uncertainty band around the FY23 average CPI forecast of 6.7 per cent. Buffeted with repea­ted supply-side shocks, the MPC might feel the urgency to push the policy rates closer to neutral territory before turning more data dependent. In June 2019, when the policy stance was changed from “neutral” to “accomm­odative”, the repo rate was reduced from 6 per cent to 5.75 per cent. If this historical pattern of defining the neutral rate is followed, then a 50-basis point (bp) hike in the September policy to bring repo rates to 5.9 per cent can be thought of as bringing rates close to the neutral zone.
 

The RBI has well-articulated that front-loading of rate hikes would reduce the medium term growth sacrifice and we believe that a 50-bp rate hike at this juncture would increase its credibility in achieving the ultimate target of 4 per cent CPI. Also, the current account deficit remains uncomfortably high as India’s growth momentum outpaces the rest of the world. Even from that perspective, a slightly faster pace of rate hikes could take care of the required “expenditure compression” to facilitate a current account normalisation. With most of the high frequency growth indica­tors holding up well, the under­lying narrative of a resilient growth recovery is likely to be offering the necessary comfort to the MPC to carry on with front-loaded rate hikes. 
 

Synchronous hardening of global interest rates could be another factor influencing the MPC’s decision. While we acknowledge that the RBI’s rate decision would be more a function of domestic developments, increasingly hawkish global central banks are reducing MPC’s degree of freedom as the external sector still needs capital flow support in India. Relentless dollar strength and a BoP deficit is straining RBI’s forex reserve buffers in defending the currency. If the markets perceive that the RBI rate action is lagging the other central banks, then the pressure on the currency might further accentuate.
 

In our view, there is a likelihood of the MPC changing its stance to “neutral”, which will establish that the RBI has completely reversed all the Covid-related monetary accommodations. This change in stance would also be consistent with rapidly draining banking system liquidity surplus and we do not expect any immediate measures to increase durable liquidity as it might be perceived to be contradictory to the overall policy stance.
 

If the RBI believes the inflation profile has softe­ned so much that it can trust on the lagged effect of the monetary actions to take care of the rest, then a 35-bp hike might be considered appropriate. From a macroec­ono­mic impact point of view, it is difficult to finely distinguish between a 50-bp and a 35-bp rate hike — both are front-loaded rate hikes of higher than usual dimension. How­ever, the “signaling effect” of a 50-bp rate hike might just be what the doctor ordered for preserving macro stability now. 

The writer is MD and chief economist, India, Citigroup