RBI Monetary Policy: One last rate hike now but signaling close to the peak

Inflation remains sticky and most G-10 central banks may in any case, continue with rate hikes; given India's resilient growth momentum, the MPC might increase the repo rate one final time

The balance of probability is that the Monetary Policy Committee (MPC) will:

(i) hike the repo rate by 25 basis points (bps) to 6.5 per cent and

(ii) signal a pause while it assesses the impact of the rate hikes across various channels on the growth – inflation balance.

There is likely to be some dissent among MPC members on the rate actions and the stance. More than the rate action, forward guidance communication will be most watched in the policy.

Why a 25 bps rise, not a pause? The following are some reasons, based both on macro-fiscal fundamentals and statistical analytics.

First, on the global economy. Over the past couple of days, the US Fed hiked its policy rate by 25 bps and the ECB and Bank of England by 50 bps each, on the basis of their assessments of persisting inflationary pressures and tight labour markets in their respective geographies. Most G-10 central banks are likely to continue with rate hikes, though at a slower pace. There seems to be enough resilience to allow central banks to engineer a policy tightening path resulting in a soft or “softish” landing, with a short and shallow recession at worst. The IMF, in its recent update, forecasts US and Euro Area 2023 growth at 1.4 per cent and 0.7 per cent YoY, respectively.

Second, India's growth momentum remains resilient. Though there are some signs of growth moderation, the broader set of economic activity indicators suggest robust aggregate demand. The eight Core Sectors Index for December 7.4 per cent YoY growth, for instance, suggested strong manufacturing. So does the reported GST collections of Rs 1.56 trillion in January 2023 (reflecting largely December 2022 activity). Yet, the January Manufacturing Purchasing Managers Index (PMI) moderated to 55.4 from December’s 57.8. Merchandise exports obviously have slowed and remain an area of concern in 2023, given the expected slowdown in global trade.

Inflation remains sticky, which is the main reason we believe that MPC will (and should) increase the repo rate, one final time. While the recent drop to 5.84 per cent is mostly due to a relatively small selection of vegetables, edible oils prices, the wider basket of food items still remains pricey. Of greater concern, core inflation still remains sticky, and multiple measures of momentum and breadth suggest only a slight relaxation of demand pressures. In addition, China’s growth is forecast to rebound to 5.2 per cent in 2023, which will have an impact on commodities and energy prices.

The MPC decision is also likely to be influenced by the fiscal stance. The FY24 union budget has continued on the glide path of fiscal consolidation and eschewed significant consumption-oriented stimulus. The focus on investment will also help in the medium term, by easing logistics and supply bottlenecks, reducing production and transportation costs.

Reinforcing these macro impressions with analytics, RBI research indicates a neutral real three-month T-bill rate of 100 bps. Given a one-year-ahead five per cent CPI inflation forecast, that’s around six per cent (the T-bill rate is now 6.5 per cent). However, policy still needs to be “restrictive” given the growth-inflation view, hence the appropriate repo rate at this point will probably be in the 6.25-6.50 per cent range. But 6.5 per cent is probably the peak and will remain so for some time till there is a durable drop in inflation, including the core component. That’s when the rate cuts in the cycle begin, but it’s a long time away.

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