Will the RBI hike interest rates or not?
The debate had been going on since the U.S. Fed stated it would hike rates. Shaktikanta Das, the Governor of RBI, said they did not see the need for a rate hike as the inflation was well within the range at the beginning of April. Despite the inflation rising over RBI’s threshold of 6 percent, the repo rate remained unchanged at 4% on 8th April 2022.
The annual retail inflation rose to 7% in March, the highest ever in the last 17 months, above the upper limit of 2-6% for three consecutive months. The headline inflation surged due to food inflation, while the high-frequency price indicators for April signaled the rise in food prices would continue. Moreover, the increase in domestic petrol prices affected the core inflation in March, and their effect intensified in April.
The Monetary Policy Committee (MPC), to ensure that they achieve their medium-term target for consumer price index (CPI) of 4% +/- 2% (Four percent, plus or minus two percent) and support growth, announced an interest rate hike on 4th May 2022. The RBI declared an increase of 40bps on repo rates and the cash reserve ratio (CRR) by 50bps effective immediately in an unscheduled press briefing.
What could be the reasons for the sudden hike?
Global environment: Since the April MPC meet, the market conditions worsened because of economic disruptions like war, shortages, geopolitically induced price rises, sanctions, and increasing downside risks. Moreover, the International Monetary Fund (IMF) lowered its forecast for global output growth by 0.8% to 3.6% within three months. The World Trade Organization (WTO) has also decreased its world trade growth forecast by 1.7% to 3%.
Domestic environment: The economic activity in India stabilized in March-April as the third wave of Coronavirus reduced and the restrictions eased. Urban demand rose, but rural demand remained weak. Investments gained traction while merchandise exports had double-digit growth for fourteen consecutive months. As domestic consumption rose, the non-oil and non-gold imports grew steadily.
High liquidity in the market: The liquidity in India remained largely surplus while the bank credit rose 11.1% Y-O-Y by 22nd April 2022. However, India’s foreign exchange reserves dropped to ~$600bn in the same month.
High-frequency inflation metrics soared: The headline CPI inflation rose to 7% in March from 6.1 percent in February due to geopolitical spillovers. Food inflation increased 154 bps to 7.5%, and core inflation jumped 54 bps to 6.4%. Inflationary pressure widened globally while the IMF forecasts suggested that inflation would rise 2.6 bps to 5.7% in developed economies and 2.8 bps to 8.7% in the emerging markets and developing economies in 2022.
Global economic outlook: Whether inflation will rise further or fall under the threshold is uncertain as it is highly dependent on the changing geopolitical situation. Global commodity prices drove food inflation, including the prices for other inflation-sensitive items. Global shortages caused due to low output and export restrictions have impacted the prices of these items. High and volatile international crude prices also pose a risk to inflation both directly and indirectly. Core inflation could remain high in the next few months because of high-domestic petrol and essential medicine prices.
Repeated lockdowns and supply chain disturbances due to the resurgence of COVID-19 in key economies like China, could keep the logistics costs high. These factors pose significant upside risks to the inflation route the MPC set out in April.
Domestic Economic Outlook: The forecasts of a normal monsoon will improve the prospects of Kharif crops. The contact-intensive services may recover steadily as the third wave ebbs while the vaccination coverage grows. Robust government CAPEX, better capacity utilization, strong corporate balance sheets, and conducive financial conditions could help to increase investments.
But the deteriorating external environment, high commodity prices, dogged supply bottlenecks, and unpredictable spillovers from monetary policy normalization in developed economies could derail this progress. India could likely withstand the deterioration in geopolitical conditions; however, it may be wise to monitor the risks.
The MPC believes that while the economy is resilient and navigating the market forces because of its strong fundamentals, the risks to the near-term inflation are emerging rapidly. These risks were apparent in the inflation print for March and April. Considering the reasons above, the RBI expects inflation to stay elevated, which calls for a firm plan to control inflation and contain the second-round effects. So, the MPC decided to increase the policy repo rate by 40 bps to 4.40%. RBI wants to stay accommodative while withdrawing the liquidity to ensure inflation is within the threshold.
RBI Rates Hiked –Now What Can You Expect?
Expensive Loans: Analysts believe the low-interest home loan era will end now. Low-interest rates have been driving the spate of home sales in India for the last two years. However, the rise in interest rates will impact the overall acquisition cost for homebuyers inhibiting residential sales. Moreover, this rise will affect all loans from home to personal loans.
Higher Deposit Rates: On the other hand, the FD rates will rise, motivating depositors to lock their funds in short-tenure FDs to enjoy the benefits of high-interest rates. The Chief economist of the Bank of Baroda, Madan Sabnavis, believes the external shocks may not stop, but the hike may regulate excess demand pressures.
Investments: Investors expected the interest rates to go up. However, the announcement came as a surprise. The market expected a hike of 25 bps, but the RBI raised rates by 40 bps. Experts believe the indices would take their cues from the actions of the Federal Reserve and other global central banks. As soon as RBI hiked rates, the markets tumbled. The S&P BSE Sensex fell over 1100 points to 55800 levels, and the Nifty dropped 1.5% to the 16,800 mark.
Experts believe there may not be many falls from the current levels, but there could be volatility due to global and domestic developments. The markets may eventually improve when the economy recovers, as seen from the latest GST collection.
While RBI rate hike effects may not be apparent immediately, it remains to be seen if inflation will drop as liquidity in the market falls.
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