Tightening to continue

RBI has to cover more ground

The Monetary Policy Committee (MPC) is expected to further increase the policy repo rate this week. While the consumer price index-based inflation rate has moderated, it is still at a significantly high level. The rate in June, for instance, was at 7.01 per cent as against 7.79 per cent in April. Global commodity prices have come down over the past few months, but are still elevated and there are other risks that the MPC would need to consider. The global economy is rapidly losing momentum and the recovery from the pandemic-induced disruption is weakening. The International Monetary Fund, for instance, now expects the global economy to grow by 3.2 per cent in the current year, which is 0.4 percentage points lower than its April projection. The growth projection for the US economy has been pared by 1.4 and 1.3 percentage points for 2022 and 2023, respectively.

A slowing world economy and the possibility of some developed economies slipping into a recession could further lower commodity prices. Although India tends to benefit from lower commodity prices, the gains could be somewhat limited this time. For instance, the increase in crude oil prices was not fully passed on to retail consumers. A decline in global prices thus may not result in lower retail prices and inflation. Besides, the ongoing Ukraine war and further disruption in gas supplies from Russia could push up global energy prices. Slower global growth would also affect India’s exports and keep the current account deficit elevated, affecting the rupee with implications for inflation outcomes.

Aside from the current account, uncertainties on the capital account will also keep the currency under pressure. The US Federal Reserve raised rates by another 75 basis points last week. Interestingly, financial markets rallied after the hike, which perhaps indicates the level of liquidity in the system. It is worth noting that the Fed intends to bring down inflation to its target of 2 per cent, which will need significant disinflation from the current rate of over 9 per cent. Sustained rate hikes could keep the global currency market volatile. This would have a bearing on the rupee, affecting inflation outcomes, among other things. Internally, the renewed pressure building in food prices would be a source of worry for the MPC. After a drop in wheat output because of the heat wave, uncertainty has increased for paddy production. Sowing so far has been lower by about 13 per cent than it was last year because of poor rain in some regions. As a result, rice prices are reported to have increased 8-16 per cent in different trading centres.

Given the domestic and international backdrop, analysts expect the MPC to increase the repo rate by 30-50 basis points. It would make sense for the committee to raise the rate by 50 basis points. Since it still has to cover significant ground to reach the neutral rate, delaying the rate action would not help. The level of liquidity in the system has come down significantly. The inter-bank call rate went above the repo rate last week, though it may partly be because of tax outflows. The Reserve Bank of India’s currency market intervention also seems to have played a significant role. Liquidity adjustment followed by a rate hike this week would help the central bank regain some ground.