Monetary Policy | MPC frontloads to play catch-up

In an inter policy meeting, the RBI MPC on Wednesday surprised many by unanimously voting to raise the repo rate by 40 basis points (bps) to 4.4 percent. It, however, kept the stance accommodative, while focusing on withdrawing accommodation.

With March inflation print exceeding the RBI's target range materially, and the next two quarters also in line to overshoot 6 percent (April print likely around 7.5 percent), the RBI has been pressed to act sooner than later. Moreover, with inflation realities worsening, the next move will be a hike (in June), with or without stout and formal stance change. The need for formal change in stance will only occur when the policy rate is on its way to become restrictive and growth impinging. At this point, the rate increase merely reversed the 40 bps cut delivered in May 2020.

Inflation urgency and global externalities tie RBI’s hand

The front-loaded out-of-turn rate hike only strengthened the view that urgency from the MPC end has only increased with inflation uncertainties and with the need to do policy catch up. While it could have frontloaded the hikes in April itself, we think the MPC was constrained by its own language in February where it stated the need to telegraph its action well before. The April MPC policy gave it that platform to telegraph, only to act yesterday -- just ahead of FOMC meeting which raised rates by 50bps.

We note that even though until early 2022, most Asian EM central banks, including RBI were largely dovish-to-neutral, most of those Asian economies have been facing relatively moderate inflation pressures, ranging from 2-4 percent, while India’s inflation has been hovering above 6 percent. As most EM Asian CBs change their narrative to catch up with the Fed, the RBI is pressed to do much more, given worse inflation dynamics. This also precludes any overt pressure on the Indian rupee (INR) amid RBI’s supposed rhetoric.

CPI inflation may peak at still a very high level in April, assuming pump prices stabilize ahead. With food prices looking high in the near term (summer effect, international prices, higher transport cost, supply chains) and persistent input cost pressure in the non-food segment, we see inflation crossing 6.1 percent in FY23. The RBI is also seeing upward risks to its inflation forecasts. The governor also reckoned that the triple whammy of commodity-price shocks, supply chain shocks and resilient growth, has shifted the reaction function in favor of inflation containment. He also noted that broad-based global price shocks were emanating from rising commodity prices, with the pass through starting to become visible, especially in food prices. Looking ahead, the RBI sees food prices staying elevated, wherein spillovers from global food shortages could translate into another round of price pressures.

Yesterday’s action again hints that policymakers no longer think the output sacrifice required to tame supply-driven inflation can be as high. Thus, to that extent, the RBI reaction function is now evolving with fluid macro realities. We see June policy to be live, and MPC may frontload rate hikes by another 25bps or more. FY23 could see overall rates go up by at least 125 bps. The terminal rate may be around or tad higher than 5.50 percent, with the RBI now showing its intent to keep real rates neutral or above.

The gradualist approach toward liquidity and rate normalization may be challenged by various global and domestic push-and-pull factors. Nonetheless, a huge bond supply in FY23 will require the RBI's invisible hand, implying the return of tactical OMOs, especially as the BoP deficit could soar to $50 billion in FY23. The RBI may neutralize this partly with more CRR (cash reserve ratio) hikes (yesterday’s 50bps hike sucks out Rs 87,000 crore banking liquidity) if it intends to bluntly reduce banking liquidity. Operation Twist, while an attractive option to ease term premia, may be constrained as the residual maturity profile of government securities in the RBI's book (12-15 months) could be thin.