‘The MPC unanimously decided to increase the policy repo rate by another 50bps to 4.90%. The front-loaded hikes are no surprise as the RBI had already de-anchored and readjusted market expectations on policy moves and would have thus preferred to optimize on the same to minimise market impact.’
By Madhavi Arora
- Another front-loaded hike of 50bps reflects increased policy urgency with heightened inflation uncertainties. The Governor again stated that its reaction function is not tied to any defined playbook and is reactive to evolving global macro backdrop and inflation dynamics. The policy rhetoric was accompanied by focus on withdrawal of accommodation, albeit in nuanced fashion. Inflation forecast has been raised again to at 6.7% from 5.7% earlier led by food inflation, with H1FY23 seeing 7%+ prints. The GDP growth estimate is kept unchanged at 7.2%.
- While August may see another frontloaded hike of 25bps+, FY23 could see overall rates go up by another 75bps+. The terminal policy rate may be around 5.75%, while net liquidity tightening to 2% of NDTL is tantamount to another estimated 25bps of effective rate hike.
- Liquidity transition could be edgy. A huge FY23 bond supply will require the RBI’s invisible hand (tactical OMOs), which the RBI may neutralize partly with more CRR hikes if it intends to bluntly reduce banking liquidity. Operation Twist, while an attractive option to ease term premia, may be constrained due to thin Gsec residual maturity profile in the RBI’s book. We maintain a case for mild Gsec bear-flattening bias.
RBI expectedly continues with front-loading
The MPC unanimously decided to increase the policy repo rate by another 50bps to 4.90%, implying SDF and MSF increasing to 4.65% and 5.15% respectively. This comes after the inter-meeting hike of 40bps in May. The front-loaded hikes are no surprise as the RBI had already de-anchored and readjusted market expectations on policy moves and would have thus preferred to optimize on the same to minimise market impact. The stance continues to be focused on withdrawal of accommodation, aimed at keeping inflation contained while supporting growth. However, the Governor also maintained that the RBI will continue to adopt nuanced approach to liquidity management even as they move towards normalisation going ahead. The Governor stated in the presser they aim to get the weighted call money rate more or less aligned with the policy repo rate over the coming months.
Inflation urgency and global externalities tie RBI’s hand
The front-loaded hikes 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. Amid new macro realities, the inflation forecast has been raised 6.7% from 5.7% in April (4.5% in Feb), with 75% of the revision led by higher food prices. H1FY23 would see inflation averaging above 7.4%. Brent is assumed at US$105/bbl (US$100/bbl earlier) and the forecast does not consider the impact of rate hikes from June onwards. The RBI flagged the ongoing impact of rising imported price pressures on goods inflation, as well as the broadening of inflation pressures. The Governor also noted that Europe war has led to a “globalisation of inflation”, which is pushing central banks to reassess and re-calibrate their policies. The RBI reckoned the supply side policy response (fuel excise cuts) of the government significantly impacted HH expectations and insisted that states follow suit. The GDP growth estimate is kept unchanged at 7.2%, with broadly balanced risks. The RBI maintained that domestic recovery remains firm and consumer confidence remains robust.
Front-loading to continue, but watch out for the terminal rate
Overall, today’s 50bp rate hike is in line with our expectations of RBI remaining front-loaded, after un-anchoring markets’ policy expectation in Apr/May. The triple whammy of commodity-price shocks, supply-chain shocks and resilient growth, has shifted the reaction function in favor of inflation containment. The reaction function is now evolving with fluid macro realities. The inflation prints of next two quarters are likely to exceed 7%, which could pressure the RBI into acting sooner rather than later. FY23 could thus further see rates going up by 75 bps+, with the RBI now showing its intent to keep real rates neutral or above to quickly reach pre-Covid levels. Our Taylor’s estimate shows a max tightening of policy rate by 6% by FY23, of which liquidity tightening to 2% of NDTL is tantamount to another estimated 25bps of effective rate hike. However, the front-loaded rate-hiking cycle does not imply a lengthy tightening cycle, and once they reach the supposed neutral pre-Covid monetary conditions, the bar for further tightening incrementally may be higher amid increasing growth-inflation trade-offs. We reckon that amid the persisting slack, the flatter Phillips curve may call for a larger output sacrifice to contain inflation. A judicious policy mix is needed as economic agents share the burden of the global shock. The countercyclical fiscal shield can be effective while the monetary sword takes hold.
The journey of liquidity transition will still be edgy
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 USD50bn in FY23. The RBI may neutralize this partly with more CRR hikes 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 Gsec in the RBI’s book (12-15 months) could be thin. We maintain that a mild bear-flattening bias in the Gsec curve may prevail.
(Madhavi Arora is the Lead Economist at Emkay Global Institutional Equities. The views expressed in the article are of the author and do not reflect the official position or policy of FinancialExpress.com.)