The forthcoming Monetary Policy Committee (MPC) review is likely take to forward the policy pivot initiated in the early April MPC review and then reinforced in the surprise off-cycle meeting in early May. Multiple scenarios of the trajectory of the monetary policy response, using a combination of economic forecasts and market signals, are being debated by analysts and markets.
This article aims to supplement these arguments by drawing upon a range of empirical results from RBI’s own econometric research. These provide a very useful analytical scaffolding, helping to better understand the monetary policy response function by applying the results to emerging data. A recent article in particular, written by RBI experts, provides a comprehensive collation of insights from previous and continuing research.
The April MPC statement had stated the shift in policy response priority: (i) inflation control, (ii) sustaining growth and (iii) maintaining financial sector stability.
The first RBI result is that inflation beyond the 6% threshold begins to hurt growth. CPI inflation could average 6.5-6.7% in FY23, remaining above 7% in the first two quarters. This forecast is arrived at after factoring in the effect of the auto-fuel excise and VAT cuts and a range of fiscal, trade, and industrial measures, as part of a coordinated response.
However, a significant amount of input cost pass-throughs still seem to remain, based on an analysis of Q4 financial results of listed companies. Services inflation is likely to add to the pressures.
The second result from the RBI workhorse New Keynesian model suggests that market failures create stickiness in prices of goods and services and wages. One of the market failures in India is likely to be the increasing evidence of concentration of spending power in the top two-three deciles, which aggravates this stickiness. The Marginal Propensity to Consume of these deciles is low, and their large savings are likely to provide a buffer against high prices. Monetary policy will have to be supplemented by other policy instruments.
The third result suggests that a 1 percentage point (pp) change in the real interest rate gap leads to a 0.2 pp change in the output gap. This means that every 1 pp hike in rates will cut growth only by 20 bps, which means that a strong rate response might be required to tame inflation.
The fourth result pertains to the second priority, growth. At what point in the rate hike cycle does the sacrifice ratio turn adverse, when the cost of rate hikes outweighs the benefits of anchoring inflation expectations? The response, however, should not be so strong as to kill growth, which is formally recognised in the fourth result: Recent Taylor Rule weights for India are 1.2 for inflation and 0.5 for growth.
Contrast this to the probable trade-offs the Federal Reserve might be working with, with the growth weight likely to be close to zero. This suggests that the RBI rate hike intensity will not mirror that of the Federal Reserve.
The country’s GDP growth could come in at 7.1% in FY23. In the near term, high-frequency indicators show strong economic activity. Services indicators also remain strong. Credit offtake pertaining to retail loans suggest consumption demand remains strong.
Yet, already, there are signs that demand for discretionary purchases have weakened. Wealth effects from the equities markets are likely to wane.
The third priority of the monetary policy response is financial sector stability. This time, transmission in India to bank lending rates will be very fast; interest-rate resets will happen quickly. More than 70% of MSME and mid-size corporate loans are now linked to External Benchmark Linked Rates (EBLR, mostly to the repo rate), as are 58% of the home loans. In tandem with slowing growth, the potential stress on weaker borrowers is likely to increase. Short-term market funding rates have already moved up by almost 2 percentage points since October 2021 (see graphic).
Given the multiple trade-offs highlighted above, and the analytical moorings that are likely to shape the policy response, there is a clear need to calibrate the rate hikes based on incoming economic data.
The other instrument to moderate aggregate demand is the level of surplus system liquidity. The fifth RBI result indicates that 1.5% of deposits (NDTL) is the “non-inflationary” level of surplus liquidity. Every 1% addition over this leads to a further 60 bps of inflation over the course of a year. 1.5% of NDTL is Rs 2.6 trillion. Current liquidity is averaging about Rs 3.7 trillion and is likely to revert to Rs 4.5 trilion by mid-June, due to expected increases in the Centre’s spends. This is still uncomfortably higher than the indicated threshold, which might necessitate another CRR increase in either the June and August reviews, or in between (CRR can be raised any day, since this is not an MPC instrument), depending on the evolving liquidity conditions.
The expected rate hikes in the US and some other G-10 central banks are likely to be at a pace not seen in almost a generation. This is bound to throw up surprises. Some of these unintended consequences will spill over into emerging markets, including India. RBI and MPC will have to respond to both global and domestic risks as and when they emerge and evolve.
The author is Executive vice-president and chief economist, Axis Bank Views are personal