Opinion

We must brace for a barrage of rate hikes

Michael Debabrata Patra, deputy governor in Reserve Bank of India, is in the good company of Soren Kierkegaard, Friedrich Nietzsche, Ivan Turgenev and other nineteenth century European philosophers. He rides on the minutes of the monetary policy committee’s June meeting to lash out at the central bank’s critics by calling them, somewhat strangely, “nihilists”, or those who believe in the uselessness of existence and truth.

But going beyond the limited utility of philosophical epithets and showboating, the Monetary Policy Committee (MPC) minutes for the meeting held during 6-8 June, in which the panel decided to increase the policy repo rate by 50 bps to 4.9%, do provide some indications of monetary policy’s path ahead as it grapples with aggravated inflation and threats to incipient growth impulses. The minutes also reveal some minor differences between members in how they calibrate their optimization. This is a space that seems interesting and needs further watching.

One thing is clearly emerging from the minutes: the MPC is likely to keep increasing its benchmark repo rate till the real rate is a positive number. The repo rate is currently at 4.9% and the year-end inflation is projected at 5.8%. Therefore, for real rates to return to positive territory, the extent of increase is likely to range between 75-100 basis points.

There is only one hitch here: the inflation projections have been provided in RBI’s June monetary policy and, as things stand, material conditions can change drastically any time, in any direction. Three key variables point towards either similar conditions prevailing or a worsening of the situation.

One, end-game in the Russia-Ukraine war looks slightly distant at this juncture. This will continue to exert pressure on food and oil prices globally; Hence, it is unlikely that the inflationary pressures will ease any time soon. Two, central banks in advanced economies will continue to march down the path of monetary policy normalization, providing emerging economies with exchange rate volatility and the potential of imported inflation. Three, the spectre of an economic slowdown in the advanced economies is likely to affect growth prospects which, when combined with rising prices, presents central banks with a classical dilemma.

It is also becoming clear that RBI will be increasing rates reflexively and repeatedly. Here is why.

While inflation expectations are backward looking – in the sense they are formed on the basis of historical data, given that inflation data is always released with a lag – the RBI’s desire to keep the repo rate above the four quarters ahead forecast of inflation will be difficult , given the mercurial nature of material conditions driving prices at this moment. The extent of rate action will, therefore, vary from meeting to meeting, most likely depending on the last inflation print. The RBI’s instinctual actions in May and June bear testimony to this.

Patra, in one place, says that the key thing to watch out for is “the direction of inflation, not its level, which will remain elevated for some time in view of the overwhelming shocks.” But, earlier in the minutes, he also says: “Yet, for monetary policy, rather than materially compressing demand, managing expectations is the key.” If we are to take him at his word, the RBI will have to keep increasing rates, even if the direction is lateral, because elevated inflation has a way of keeping expectations firm.

A lot of how monetary policy will pan out in the future will also depend on how the MPC members view the state of demand.

MPC member Shashank Bhide points out that dark clouds hang over growth prospects: “…there are clearly uncertainties regarding the growth prospects, particularly in view of the emerging adverse global demand conditions with the global output and trade volume growth now expected to be lower in 2022 than in 2021…The RBI’s Consumer Confidence Survey conducted during May 2-May 11, 2022 in the major urban areas shows weaker optimization in the general economic conditions for one-year ahead, with overall household spending expected to increase due to higher ‘essential expenditure ‘, also for one-year ahead.”

Even Ashima Goyal is circumspect about demand recovery: “Corporate surveys show that input price indices have risen more than output price indices and yet, mark-ups have remained constant. It is wage share that has fallen. This is the classic low demand response. India did not have excess stimulus like in the US, and excess demand is not adding to inflation pressures here.”

This is in sharp contrast to the demand and growth prospects voiced by RBI nominees on the MPC. RBI governor Shaktikanta Das notes: “Growth impulses, on the other hand, are broadly evolving in line with expectations as borne out by the available high-frequency indicators during April-May 2022…while high inflation continues to be the major concern, revival of economic activity remains steady and is gaining traction.” Patra also echoes similar sentiments: “High frequency indicators for May point to expansion in demand. This warrants some monetary policy front load to modulate it so that even though it is not at full strength, it does not exceed the available supply.”

These differences will undoubtedly play out in future MPC meetings, though it is doubtful whether the minutes will reflect them candidly.

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