The central bank is fighting twin battles at this point. It needs to control inflation that is way above its mid-term target of 4 percent and has been consistently above the upper band of 6 percent. On the other hand, the nascent recovery seen on the economic growth, needs to be supported.
The central bank-led monetary policy committee (MPC) clearly misjudged the inflation trajectory for a prolonged period in its bid to support growth recovery. The stance remained accommodative for a long time which led to differences even within the panel.
In May, the rate-setting panel then embarked on a catch-up game by initiating sharp rate hikes in two rounds, totaling 90 basis points (bps). One basis point is one hundredth of a percentage point. The MPC has signalled to take the rate back to pre-pandemic levels.
The repo rate, which is currently at 4.9 percent, can go up by at least 100 basis points, according to economists considering the inflation expectations. That means the operative policy rate will likely go up to 6 percent eventually and even above. But, it’s not just inflation. Global factors—the trajectory of global rate hikes and the ongoing Ukraine war—will play a critical role in deciding the course of domestic interest rates. If the US Federal reserve hikes rates by another 50-75 bps, the Indian central bank will be constrained to go for a bigger rate hike to prevent flight of capital due to the widening interest rate differential. This will have big ramifications in the domestic credit market.
A sharp surge in domestic interest rates could hurt smaller companies more as their borrowing costs surge. It could also impact demand on consumer loans as the interest repayment burden on home, auto loans surge. A lull in demand can hurt industries. Higher interest rates could also eventually lead to stress build up on the books of banks especially when it comes to lending to mid-sized companies.
But, the MPC is likely to ignore these factors as the primary agenda is to bring down inflation that is consistently staying above the central bank’s comfort level. The rate-setting panel will need to also convince the government on the rate stance as rising yields will add to government’s borrowing costs.
Bond yields have escalated in the recent past. The yield on India’s 10-year bond is trading at 7.45 percent now and has eased nearly 18 bps since mid-June. The Rupee remains weak. The RBI-led MPC is keeping a close watch but, as said above, it is caught in a tough twin battle.
(Banking Central is a weekly column that keeps a close watch and connects the dots about the sector's most important events for readers.)