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MPC | RBI must avoid its Volcker moment

A large hike in the policy rate, will lead to a further exacerbation of the economic growth, and unemployment in India 

September 28, 2022 / 08:34 AM IST
The Reserve Bank of India (RBI)’s Monetary Policy Committee (MPC) meets today. (File image)

The Reserve Bank of India (RBI)’s Monetary Policy Committee (MPC) meets today. (File image)


The United States being the largest economy in the world is still suffering the negative effects of persistently elevated levels of headline inflation. The headline inflation in the US was recorded at 8.3 percent in August, and has been in the range of 7-9 percent for the past few months. As a result, the US Fed funds rate was hiked consecutively five times this year by 275 basis points.


US Federal Reserve Chair Jerome Powell, at the Jackson Hole Economic Policy Symposium in August, remarked that henceforth the FOMC’s principal focus will be to bring down inflation below the 2 percent target, and maintain price stability. These Fed fund rate hikes indicate that recessionary fears will last in the US economy, and anchoring inflationary expectations will be dealt with more strictly. This reminds us of the era of the former Fed Chairman, Paul Volcker, who used an iron fist to anchor inflationary expectations successfully.


With India also reeling under high inflationary pressures in recent times, and being prone to be impacted by US monetary policy, it would be interesting to note the Reserve Bank of India (RBI)’s Monetary Policy Committee (MPC) move on September 30.


Higher US interest rates will have a detrimental impact on the already vulnerable Indian Rupee on account of narrowing interest rate differentials between the US and India. The rupee depreciated against the USD and breached the level of Rs 81 per USD, and traded at around Rs 81.15 per USD on September 23.


In this financial year, the rupee has seen more than 5 percent depreciation. To control currency volatility, the RBI has intervened in the foreign exchange market on a continuous basis. As per the WSS data released on September 23, India’s foreign exchange reserves declined by around $5 billion to $545.652 billion registering the lowest level of foreign exchange reserves since October 2020. The RBI spent around $19 billion in the last one month to arrest the rupee’s volatility.


As a result of this persistent fall of the rupee, India’s fight against inflation has become more challenging given high global crude oil prices, and India’s dependence on oil imports. The Consumer Price Index (Combined) has breached the inflation target consecutively for the past eight months, whereas the Wholesale Price Index (WPI) has been in double digits for 17 consecutive months, even though there was a declining trend most recently.


All these factors certainly make a case for an aggressive interest rate hike in India. However, any discussion on inflation, exchange rate, and monetary policy would require a careful review of the growth situation. India’s Q1 GDP growth is estimated to be at 13.5 percent, which is still lower than the RBI’s growth projections of 16.2 percent for the same period in its last monetary policy resolution in August.


Growth has largely been consumption driven as investment growth had declined. India’s Gross Value Added (GVA) for Q1 registered a growth of 12.7 percent on a Y-o-Y basis, which was lower than the previous year. The services sector posted modest growth, while the manufacturing sector decelerated across various sub-sectors. The Index for Industrial Production (IIP) for mining and manufacturing in the Q1 of FY 2022-23 declined as compared to the previous year. This raises serious questions about growth sustainability in the ensuing period. In addition to this, the unemployment rate is estimated to have increased to ~8.3 percent in August.


Against this backdrop, a large hike in the policy rate, will lead to a further exacerbation of the economic growth, and unemployment in India. Though interest rate hikes will help manage the interest rate differential to a certain extent, the FDI equity flows, which are more income- and growth-generating and also growth inspired, could be affected. Already, as per government data, FDI equity flows have decreased by 6 percent Y-O-Y in Q1 of this financial year. Besides, during the past few months, a decelerating trend can be observed in the CPI-C, and WPI. This was achieved mainly on account of the policy interest rate hikes of a total of 140 basis points by the MPC in its past three monetary policy resolutions.


The improvement in the inflation situation suggests that the MPC has been quite successful in anchoring inflation expectations. In its monetary policy announcement on September 30, the MPC should be cautious, and at the same time resolute in adopting a ‘less hawkish’ monetary policy tightening. The RBI should stick to a glide path to disinflation by moderating the interest rate hikes. It should now soften its previous scale of 40-50 bps policy rate hike, and focus on achieving price stability for aiding growth instead of demonstrating a ‘Volcker moment’ for India on the road to arresting inflation.


Preeta George is Professor, Bhavan’s SPJIMR, and Chinmay Joshi is Academic Associate, Bhavan’s SPJIMR. Views are personal, and do not represent the stand of this publication.

Preeta George is Professor, Bhavan’s SPJIMR. Views are personal, and do not represent the stand of this publication.
Chinmay Joshi is Academic Associate, Bhavan’s SPJIMR. Views are personal, and do not represent the stand of this publication.
first published: Sep 28, 2022 08:34 am