Vijay Kumar Gaba

The Monetary Policy Committee of the Reserve Bank of India, in an unscheduled meeting on 04 March 2022, decided to hike the policy repo rate by an unconventional 40bps to 4.4%. Besides, the RBI also decided to increase the standing deposit facility (SDF) and marginal standing facility (MSF) rate by 40bps to 4.15% and 4.65% respectively. The cash reserve ratio (CRR) for the banks has also been increased by 50bps to 4.5%. This action of the RBI is not entirely surprising, given that the consumer inflation (CPI) rate in the country has been consistently running close to or over the RBI’s tolerance band for the past many months.

The decision of the RBI came a few hours after an unscheduled 25bps hike by the Royal Bank of Australia (RBA) and a few hours before the much anticipated 50bps hike by the Federal Reserve of the USA (the Fed). With this over 55 central bankers have hiked their respective policy rates in the past 10 weeks. This includes about one half of the members of G-20. Interestingly, the countries struggling with financial crises and growth like Zimbabwe (2000bps); Sri Lanka (700bps) and Pakistan (250bps) have tightened most aggressively in the past 10weeks. Besides, Australia, the commodity exporters of Africa and Americas have also hiked the rates. Russia and Singapore are the only two notable countries that have cut the policy rates since March 2022.

Evidently, inflation is the overriding concern of most central bankers at this point in time. Even the central bankers like US Federal Reserve and Reserve Bank of India which were insisting that inflation is transient, being a consequence of the temporary supply chain disruptions due to the pandemic, and could be surmounted by focusing on growth, are now according higher priority to price stability rather than growth. Both the Fed and RBI have hiked rates despite palpable slowdown in the growth in recent quarters, and consensus downward revision of the future growth forecasts. Obviously, the policy decisions lacked conviction and thus did not elicit the desired response from commodity, currency and bond markets.

The Fed itself blunted its attack on inflation by ruling out aggressive hikes of 75bps in the forthcoming policy meets. The RBI governor was conspicuously apologetic while making the announcement. It is pertinent to note that bonds and currency markets were already anticipating these hikes and had discounted some of the impact beforehand; these actions were mostly expected to have “signaling” value for the markets only. By communicating a weak signal both the fed and RBI have disappointed the markets.

RBI takes a ‘curved’ path

For the past four years, the RBI had been following a straight path. It gave top priority to economic growth, followed by financial stability and price stability in that order. The commitment to this order of priority afforded it the strength to handle the pandemic led crisis remarkably well, while aiding the government efforts to stimulate the growth. Both the RBI and the government were seen operating in perfect tandem, unlike in the preceding years when the monetary and fiscal policies were often at odds.

With this decision, the RBI seems to have deviated from the straight path to take a curvaceous road. Under the pressure to stay on or ahead of the ‘curve’, the RBI has distorted its order of priorities.

It is a common belief that most of India’s current inflation has been caused by (a) high prices of imported energy, edible oil and industrial metals; (b) higher fruits & vegetables prices due to poor weather conditions; (c) rise in food prices due to higher support prices and (d) global supply chain disruption impacting the production. There is no sign of over speculation in the domestic commodities markets. There is no sign of overheating in the housing or auto markets. The credit growth has been below normal for past three years. It is difficult to explain how, in the Indian context, a rate hike could calm down the prices, except by destroying the demand that itself is below normal. In fact only a couple of day ago, the RBI itself has forecasted that it will take 12 more years to fully recoup the losses suffered by the economy due to the pandemic.

On the negative side however, higher rates will further constrict the already tight fiscal space for the government. Higher interest expense would have to be compensated by lower spending, as in a falling growth environment hiking tax rates may not be a viable option. A stronger INR (due to higher rates) could negatively impact the exports that have been the only bright feature in the struggling Indian economy in the past two years.

…ignoring the latest empirical evidence

The most unfortunate part of this episode is that the RBI has not learned anything from history. During 2010-2014, when the economy was still struggling to overcome the effects of the global financial crisis, the RBI started hiking rates unceremoniously from 5% in March 2010 to 8% in January 2014. These hikes not only negatively impacted the recovery, but also weakened the financial system materially. The rate had to be cut by 50% to 4% in the next 6 years to stabilize the financial system and bring the economy back on the growth path. It is important to remember that the RBI was cutting rates consistently from January 2015 (except two hikes of 25bps each in June and August 2018). Only the last 40bps was cut as a pandemic stimulus in March 2020.

…and trampling on the nascent economic recovery

A 40bps higher policy rates, in conjunction with the 50bps hike in CRR and 80bps hike in the effective reverse repo (including 40bps done in April MPC meet) will definitely tighten the money market, impacting the working capital facilities and short duration personal loans. Given that we are in a lean season, the impact on the overall credit market may not be visible immediately, but the impact on growth may be felt in 2HFY23. The higher cost of capital may further delay the elusive capex recovery.

Impact for equity markets

A popular saying in the equity markets literature says, “Market stops panicking when the central bankers begin to panic”. If we go by this saying, we should be expecting a bottom in the equity markets very soon.

I am not sure if this saying will come true this time (even though I am secretly wishing for it). In my view, the markets will eventually call the bluff of central bankers and force them to revert to the straight path. Till then I expect the equity markets to stay volatile and range bound. Obviously, this market is for the swing traders to make money. For investors, it may be advisable to follow another popular market saying – “Sell in May and come back in October”.