By Anubhuti Sahay
The Monetary Policy Committee’s (MPC’s) rate hike and hawkish commentary on June 8 did not come as a surprise to the market, following its unexpected 50 basis points hike in both the repo rate and the cash reserve ratio (CRR) on 4 May. In fact, the rates market was relieved with only a 50 basis points repo rate hike to 4.90% (which was in line with market expectations) in June and no further measures to withdraw liquidity (read—no CRR hike).
The focus is now on the quantum of further rates hikes, which presently appear increasingly likely after the MPC’s sharp upward revision to the FY23 (year ending March 2023) Consumer Price Index (CPI) inflation forecast (by 100 basis points to 6.7%). The MPC has already delivered 90 basis points of repo rate hikes between April and June; the effective rate increase has been 155 basis points.
While it is difficult to forecast with accuracy the terminal repo rate amid an uncertain global environment with the current Ukraine crisis amidst other things, we presently expect the repo rate to be increased to 6% by end-December 2022. We base our view on two metrics.
First, we believe the terminal repo rate will crucially depend on the preferred real rate by the MPC for the economic cycle (not just the next 12 months). In recent meetings, Governor Das and Deputy Governor Patra defined the real rate as the repo rate adjusted for 12-month ahead inflation expectations. India has usually had a real rate in the 100-150 basis points range, barring a few episodes when it turned negative or was abnormally high. In our view, a real repo rate of more than 100 basis points is unlikely to be preferred against the current backdrop of an uncertain global outlook amid fears of stagflation/recession. We expect India to grow 7% in FY23, before settling in the 5.5-6.5% range over the next few years. Unless growth is far more robust than currently expected, preference for a real rate higher than 100 basis points appears unlikely to us.
Second, we expect inflation to ease over the next two to three years; this means that real rates will continue rising every year, assuming repo rate hikes end by December 2022. In one of the recent MPC minutes, Dr. Ashima Goyal noted that real rates should not be volatile. Hence, the real rate cycle and its stability will have to be kept in mind while delivering rate hikes over the next few meetings. If rates hikes in the near term are more aggressive amid elevated inflationary pressures, this could dampen growth prospects and trigger a reversal in rate increases sooner rather than later, in our view.
While the MPC/RBI is yet to release its FY24 inflation forecast, we believe it is likely to be closer to 5%, assuming no fresh price shocks and following the recent upward revision in the CPI inflation forecast to 6.7%. Based on the RBI’s April Monetary Policy Report (MPR), the projections for Q1-FY24 (as well as FY24) seem close to 5.5%. However, these were based on the earlier FY23 CPI inflation forecast of 5.7%, which has now been revised higher by 100 basis points. If the September MPR retains the FY24 CPI forecast, it would indicate entrenched and persistent inflation, despite moderating demand. We expect growth moderation—both globally and domestically—to become more evident as we move further into the second half of FY23/ FY24, on the fading impact of pent-up demand (especially in the services sector), reduced purchasing power amid high inflation and sharp policy rate increases. The RBI governor noted at the June press conference that rate increases take six to eight months to play out. The MPC is likely to deliver a cumulative 200 basis points of rate increases (effective rate increase: 265 basis points) by end-December 2022, based on our forecasts.
The rate increases over next six to nine months are likely to come against the backdrop of a reduced Indian rupee (INR) liquidity surplus, which will also put upside pressure on market rates. Currently, the INR liquidity surplus is close to `6 trillion. RBI aims to reduce the overall liquidity surplus to avoid fuelling inflationary pressures further. Governor Das and Deputy Governor Patra noted that a liquidity level (irrespective of whether it is a surplus or deficit) that aligns overnight rates with the repo rate is considered neutral. Currently, the overnight rate is closer to the standing deposit facility (SDF) rate (25 basis points lower than the repo rate and the floor of the corridor), so liquidity is accommodative. This switch from accommodative to neutral will be another factor that will push market rates higher and will need to be kept in mind while deciding the total repo rate hike.
Based on our FY23 CPI inflation forecast of 6.6%, we expect CPI inflation to stay higher than 7% in the first half of FY23 and remain above 6% in the second half, before moderating towards an average of 5% in FY24. With the MPC mandated to keep CPI in the 2-6% band with a medium-term target of 4%, a print above 6% would necessitate a rate hike in our view. As highlighted above, we expect headline CPI inflation to ease below 6% only by March 2023. We therefore expect a rate hike at every meeting in 2022. However, the size of the rate hike is likely to decrease with each meeting in 2022, in our view, as inflation peaks (we expect it to peak in August) and then move lower towards 6% by end-FY23. Given our inflation forecasts, we expect another 50 basis points increase in the repo rate at the August meeting, followed by 35 basis points in September and 25basis points in December.
Overall, an elevated inflation trajectory amid an uncertain commodity price outlook is likely to keep MPC members vigilant on evolving growth-inflation dynamics. Rates will have to move further higher from here, but the end point would need to assessed and reassessed with each data point and geopolitical development.
(The author is Head, South Asia, Economics Research, Standard Chartered Bank)