RBI active to curb inflation: Government has to tighten its belt for economic growth

- The size and timing of future interest rate hikes will depend on economic conditions

In line with market expectations, the Reserve Bank's Monetary Policy Committee hiked the policy repo rate by 35 basis points to 6.25 percent. The standing deposit facility and marginal standing facility rates have also been increased to 6 and 6.5 percent respectively. The committee raised the policy rate by 225 basis points during the year, the highest level since February 2019. The policy rate is still negative in real terms and is expected to turn positive only in the fourth quarter of the current year. The Reserve Bank estimates that the quality rate will decline to 5.9 percent in the last quarter of the current financial year. This rate is said to be 5 and 5.4 percent in the first and second quarters of the next financial year respectively.

Talking about policy measures, while the pace of rate hikes has slowed down, the central bank has still not reached the final rate of the current cycle due to various reasons. However, the size and timing of future rate hikes will depend on how economic conditions remain. Assuming current projections work out, inflation in the second quarter of 2023-24 will be 5.4 percent, still well above the 4 percent target.

Furthermore, if we miss the inflation forecast for the fourth quarter of the current year, it will mean that rates will remain outside the upper end of the range for the fifth consecutive quarter. This will certainly have an impact on inflation estimates. In such a situation the Monetary Policy Committee has to bring the inflation rate closer to the target and maintain it at that level for a reasonable period.

In this regard the Committee has taken this step to emphasize that core inflation should remain around the upper end of the range. Headline inflation is likely to moderate in the coming months as commodity and food prices ease, but if core inflation continues to rise, it will also pose a threat to headline data.

Apart from this, the central bank also has to monitor the policy steps of other major central banks, especially the steps of the US Federal Reserve. A portion of the financial market believes the Federal Reserve will slow rate hikes, even though economic data suggests this is unlikely. The Fed is expected to continue raising policy rates until the desired deflation is achieved. Although currency market pressures have eased to some extent, higher interest rates in the US and tightening global financial conditions warrant further vigilance as they may affect capital flows, currency movements and inflation measures.

In such a scenario, monetary tightening may continue, albeit at a slower pace, given domestic and global inflationary conditions. A tightening of monetary conditions will definitely impact growth. The Reserve Bank estimates that growth will slow to 4.4 per cent in the current quarter and further decelerate to 4.2 per cent in the fourth quarter. This will obviously be much lower than the desired level as the RBI is focusing on price stability, which is right, so the onus will be on the government to support growth.

Despite the widening trade deficit and current account deficit and the global recession, external sector risks have subsided to some extent. Softening commodity prices, particularly crude oil, is the main source of relief. In the first half of the current financial year, the price of crude oil in the Indian market was around $104 per barrel. The RBI has set the inflation forecast for the second half of the year at $100 per barrel. These prices are close to $87 per barrel. A year ago it was at $65.72. Crude oil hit a high of $139.13 on March 7 following Russia's invasion of Ukraine, before hitting a low of $83.03 at the end of November.

The dollar index rose to a high of 114.78 by the end of September and fell to a low of 103.37 on December 2 before reaching a low of Rs 83.29 per dollar on October 20. It has settled around Rs 81.25 per dollar after breaching the 81 level at least twice on November 14 and December 1.

Foreign exchange inflows have resumed India's forex reserves declined from a peak of $642 billion in September 2021 to $524.5 billion in the third week of October 2022 and then increased to $550.1 billion on November 25. The biggest change on the foreign front is the US. It is to lower expectations of an interest rate hike by the Federal Reserve.

Before the December 13-14 meeting of the Federal Open Market Committee, Fed Chairman Jerome Powell said that the time has come to slow down the pace of interest rate hikes. His comments led to a rally in the market. The Federal Reserve will cut the pace of rate hikes by 75 basis points, which have been rising since June to curb four-decade high inflation.

Retail inflation in India eased to 6.77 percent in October from 7.41 percent in September, mainly driven by a fall in food and beverage prices. With non-food, non-oil core inflation at 6 percent, retail inflation has remained above the RBI flexible inflation target (4 percent + /2 percent) for 10 consecutive months. RBI estimates retail inflation at 6.5 percent in the December quarter and 5.8 percent in the March quarter.

The inflation graph is likely to be in line with the third quarter estimate but may be higher than the RBI estimate in the previous quarter. Simply put, even though slow growth is a concern, rates should continue to rise because the fight against inflation is far from over.

RBI Governor Shaktikanta Das mentioned the negative real rate in the October monetary policy review. Earlier also when retail inflation was 3 percent and expected to increase to 3.4-3.7 percent, the policy rate was 5.75 percent. Inflation is now around 7 percent and is expected to be at least 6 percent in the second half of the year. Then the policy rate cannot stay even at 5.9 percent. This should increase. Major banks are offering interest rates between 6.25 and 6.5 percent on one-year deposits, which is much lower than the yield on one-year Treasury bills. The cut off in one year treasury bill auction last week was 6.8 percent. When did we see such a difference? What is the incentive for savers to keep money in banks?

A pause or a hike of 25 basis points may be seen in the February monetary policy to be presented after the Union Budget. The policy committee should keep its options open. Much will depend on the US Federal Reserve's decision on rates after December.