*****RBI will have to continue hiking rates for the next few quarters to get inflation under control – The Economic Times

Clipped from: https://economictimes.indiatimes.com/opinion/et-commentary/view-rbi-will-have-to-continue-hiking-rates-for-the-next-few-quarters-to-get-inflation-under-control/articleshow/91750794.cms

Synopsis

Post-pandemic, however, with the potential growth rate having fallen to 6-6.5%, RBI is likely to work with 0-25 bps positive real rate assumption to arrive at the appropriate TRR level.

Kaushik Das

Kaushik Das

India chief economist, Deutsche Bank AG

Two things have changed since the release of the March consumer price index (CPI) data that, coming at 7% against the consensus estimate of 6.4%, shocked the markets. One, FY2023 CPI inflation forecast has been revised significantly higher, with the average likely to rise even above 7%. Two, with the Reserve Bank of India (RBI) delivering an inter-meeting 40 basis points (bps) repo rate hike in one shot, the market pricing of terminal repo rate has risen sharply, with expectations centring around a front-loaded rate hike cycle.

Given the volatile nature of the global macro backdrop, it is difficult to be sure of where the terminal repo rate will eventually settle in this cycle. But looking at the interest rate cycles of the last two decades, the appropriate terminal repo rate (TRR) should be around 6.5% to get CPI inflation back to its target level of 4% over time. TRR will be higher if a 1-1.5% positive real interest rate is incorporated in a Taylor Rule formula that implies when inflation rises, the real interest rate should be increased.

Post-pandemic, however, with the potential growth rate having fallen to 6-6.5%, RBI is likely to work with 0-25 bps positive real rate assumption to arrive at the appropriate TRR level.

A Taylor Rule-implied TRR of 6.5% looks realistic, given that swap market pricing has historically overestimated the actual repo rate increase by 50-100 bps. So, if the market is pricing around 7% TRR, then the repo rate is likely to actually rise to 6-6.5% in the current cycle.

There is another indirect way to gauge the appropriate level of TRR. When the US Fed funds rate was at 0% in 2020, most of India’s short-term rates were below the reverse repo rate of 3.35%, due to large surplus liquidity. Considering the differential to have been about 325 bps in 2020, and assuming this spread will be maintained in the future as well, TRR will have to rise to about 6.5%, if the terminal Fed funds rate rises to 3.25% in the current cycle.

So, how quickly will RBI try to reach TRR level? Post the April CPI print, RBI is expected to hike the repo rate by 50 bps and 25 bps in its June and August policies, respectively, taking the repo rate up to 5.15% relatively quickly. But if May CPI inflation shows signs of printing between 7-7.5% by the end of this month, then there could be chances of even a 60-75 bps hike in RBI’s June policy, or two 50 bps back-to-back rate hikes in the June and August policy meetings. After that, RBI should hike 25 bps in each of the subsequent policies, raising the repo rate to at least 6.5% by H1 FY2024.

There is precedence in RBI hiking the repo rate by 200 bps to 6.75% within one fiscal year (FY2011), following it up with another 175 bps the next year (FY2012), taking the repo rate up to 8.5%. Given that the macro situation is now different from past cycles, TRR shouldn’t rise that much, as it would then entail risks of rate cuts soon after, thereby adding to volatility. But given the expected growth-inflation-fiscal-current account deficit mix, TRR can rise to 6.5% by H1 FY2024.

Along with repo rate hikes, RBI is expected to raise the cash reserve ratio (CRR) by 50 bps to 5% in the August or October policy, resulting in a permanent reduction of about ₹900 billion liquidity. As the large liquidity surplus will take time to come towards neutrality, it is important that RBI increases the price of liquidity to above 6%, to prevent liquidity-fuelled inflation at a later point of time.

The May monetary policy resolution stated that ‘[the monetary policy committee] also decided to remain accommodative while focusing on withdrawal of accommodation’. Although the word ‘stance’ has been dropped, this statement is confusing and dilutes the efficacy of monetary policy communication. While real rates will stay negative for a long time, even with RBI continuing to hike rates, the withdrawal of accommodation should not be linked to a time period till real rates remain negative.

It is clear at this stage that RBI will have to continue hiking rates for the next few quarters to get inflation under control. So, to give an unambiguous message – which would be more effective for monetary policy transmission and anchoring inflation expectations – the MPC should rephrase the sentence in the June policy as, ‘The MPC also decided to shift to a calibrated tightening mode to bring inflation back within the target range as soon as possible.’

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