There were no surprises on Friday. Every single economist and his neighbour had predicted a rate hike. And, Reserve Bank of India (RBI) Governor Shaktikanta Das just confirmed it. A 50 basis point (bp) hike in repo rate shows the singular focus on inflation of the monetary policy committee (MPC). One bp is one hundredth of a percentage point. With this, the MPC has hiked the repo rate - at which the RBI lends short term funds to banks - by a total of 140 bps in the current rate hike cycle.
The obvious question first: Why did the MPC go for a third consecutive rate hike today?
Answer is simple; both the government and the monetary policy makers are puzzled by such high retail inflation that is hurting all walks of life.
And that's unlikely to change in the foreseeable future.
The key takeaway from Das's speech today is that high inflation could destablise the economy. Also, don't miss the emphasis on the withdrawal of accommodative policies. This means further rate hikes cannot be ruled out.
With the inflation print hovering over the permitted upper band of six per cent for two consecutive quarters and likely to continue in the third quarter as well, MPC is just about facing a major public embarrassment, as it needs to explain the failure to meet its inflation-fighting mandate in writing to parliament.
MPC has a mandate to keep inflation between two and six per cent. On that count, it hasn't done a good job till now and a catch-up game is on.
Das admitted MPC's limitations to tackle inflation in the current situation, citing headwinds in the external sector. Unfortunately, he and his colleagues at MPC can't do much about the external risks.
Elevated commodity prices and a weak rupee top the external risk list. Rising interest rates globally have narrowed interest rate differentials among emerging markets and major economies, triggering a capital exodus. The war in Ukraine is another worry.
Foreign investors have pulled out $26.83 billion from Indian markets so far this year. The MPC is also under pressure because of a falling rupee which has declined close to seven per cent this year.
So, what's next? It is too early to say that the current rate hike cycle is over. Inflation trajectory ahead will be key, so will be the evolution of global economy and direction of the Russian war in Ukraine.
The RBI is fighting twin wars — it needs to control high inflation as well as support a falling currency. However, the central bank has only limited policy tools to counter the twin challenges that are primarily triggered by external factors. Therein lies Das’s immediate challenge.
The central bank's primary mandate is to maintain stability. Yet, it let loose the inflation genie for too long, in search of a stimulus-led growth. It is now playing catch-up with steep, consecutive rate hikes.
But raising interest rates too quickly will not bode well for Asia's third-largest economy where recovery from pandemic is still fragile.
The MPC, which sets rates in India, was obsessed with so-called accommodative stance for a considerably long time, saying pandemic -induced slowdown needs closer policy attention, even at the risk near-term inflationary pressure. The panel probably thought high inflation will cool down on its own in due course. But this assumption proved terribly wrong.
A sudden sharp rise in interest rates can hurt nascent recovery in the economy, kill demand, and even kickstart another stress-cycle. Already, borrowing costs for smaller and mid-sized companies have shot up by 200-250 bps from last year.
High interest rates will dampen demand for consumer loans, a safe haven for Indian banks hit by waves of corporate defaults. Soaring yields can also worry the Narendra Modi government as Centre's borrowing will turn costlier.
Yet, the choices before Das and his team at the MPC remain limited.