Policy rate likely to peak by January-March quarter as MPC shifts focus to growth, say economists

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The widening divergence among members of the Monetary Policy Committee (MPC) suggests that India may not be very far from reaching the end of the current rate hike cycle, at least six economists told Moneycontrol on Tuesday (October 18).

Splits in the MPC’s thought process were visible in the minutes of the MPC’s September meeting. While the majority of the members stuck to their hawkish stance on rates to tame inflation expectations, external members Ashima Goyal and Jayanth Varma said that an aggressive rate hike cycle may do more harm than good. Varma also said that it is dangerous to push the policy rate well above the neutral rate in an environment where the growth outlook is very fragile.

Once inflationary pressures recede, the rate-setting MPC will likely shift focus to address worries surrounding economic growth in FY24 and assess the impact of previous rate hikes, economists said.

“Assuming inflation evolves along our projected path and returns to the target range in FY24, growth is likely to take precedence for policy considerations as the recovery momentum fades on the passage of the reopening boost, tighter financial conditions, a tougher global growth backdrop and guarded Capex interests,” said Radhika Rao, senior economist at DBS Bank.

Policymakers are expected to stay on pause with respect to rates and signal readiness to act if growth headwinds strengthen, added Rao.

Also read: RBI likely to shift focus towards growth slowdown in 2023, says HSBC Securities’ economist

Where is inflation headed?

Currently, inflation has been the pain point for the MPC. Inflation has been consistently above the MPC’s 2-6 percent target band for three consecutive quarters. This is the definition of failure under the flexible inflation targeting framework. Per the law, the Reserve Bank of India (RBI) must now submit a report to the central government explaining why it failed to contain inflation, the remedial actions it proposes to take, and the period within which inflation will return to target.

The RBI expects inflation to average 6.7 percent in FY23. Thereafter, it expects inflation to drop to 5 percent in the April-June 2024 quarter, closer to its target. RBI governor Shaktikanta Das had given a two-year timeline for inflation to fall to 4 percent.

According to economists, the RBI’s inflation forecast appears to be in the ballpark range, but commodity price volatility may raise concerns in the October-December quarter. Unseasonal rains and the possibility of higher food inflation could also add to the upside risks, they added.

“The unseasonal rainfall may delay the kharif harvest and rabi sowing, posing a risk to the food inflation outlook,” said Aditi Nayar, chief economist at ICRA. “Additionally, the robust demand for services may impart stickiness to services inflation, going ahead.”

However, by the January-March quarter, economists expect inflation to moderate on the back of a favourable base. That could give the MPC some leeway to focus on growth, rather than on inflation, they said.

“The expected seasonal correction in food prices in the winter months, pass-through of a decline in global ex-oil commodity prices and easing core inflation amid softening pent-up domestic demand will allow CPI inflation to come closer to the 6 percent handle in Q4 FY23 (January-March),” said Garima Kapoor, economist and senior vice president at Elara Capital.

Dipanwita Mazumdar, an economist at the Bank of Baroda, shared similar views. According to Mazumdar, the key driver for the MPC will be an evolution of the inflation trajectory for now, which might exhibit some seasonal shocks. However, with the arrival of fresh crops and with a favourable base in January-March, some comfort may be felt in the numbers, she said.

Also read: September CPI at 7.41% | MPC likely to hike repo rate by at least 35 bps in December

Growth over inflation

Once inflation begins to moderate by FY24, economists expect the MPC to prioritise growth and assess the effects of policy transmission. The MPC has already hiked the repo rate — or the rate at which the RBI lends funds to banks — by 190 basis points since May. One bps equals one-hundredth of a percentage point.

“Excessive rate increases could be overkill at this time and can be dangerous to overall stability. Thus, I think the MPC must pause and wait for effective policy transmission to take place,” said Karan Mehrishi, an independent economist. “Raising rates with impunity will derail the economy's growth prospects, discouraging households from consuming and corporates from investing.”

Already, indications of a weak growth trajectory have begun to show. Industrial growth, per the Index of Industrial Production (IIP), slid to an 18-month low of -0.8 percent in August from 2.2 percent in July. Industrial growth has been falling ever since it hit a one-year high of 19.7 percent in May on the back of a favourable base effect.

The RBI estimates India’s GDP to grow at 7 percent in FY23 and 7.2 percent in April-June 2023. Economists see downside risks to these projections.

“We expect GDP growth in FY23 at 7 percent, but we do see a downside risk from the global growth slowdown, which could negatively impact exports,” said Gaura Sen Gupta, India economist at IDFC FIRST Bank. “Moreover, the impact of the rate hikes on growth is yet to be felt as transmission has been limited.”

Rate implications

Most economists also said that the MPC may raise the repo rate by another 50-60 bps in the current cycle. They expect the repo rate to rise to up to 6.50 percent by March 2023 from 5.90 percent currently.

“We expect two more rate hikes of 35 bps and 25 bps over the next two meetings taking the repo rate to 6.5 percent,” said Kunal Kundu, India economist at Societe Generale.

Eventually, however, supporting growth will take precedence, said Kundu. A 6.5 percent repo rate by January-March will pull the real policy rate out of negative territory. Since inflation will likely start easing from the April-June quarter onwards, the real policy rate will turn positive allowing the central bank to shift focus to supporting the economy, especially as the unemployment rate still remains worryingly high, said Kundu.

DBS Bank’s Rao also had similar views. “Either way, the bulk of the frontloaded moves are likely behind us,” added Rao. “We are likely to see the policy committee pause into FY24, in our view.”​