Tuesday, October 15, 2024

MPC likely to hike repo rate by 25 bps to quell inflation

The forthcoming review meeting of the Monetary Policy Committee (MPC) is likely to be a particularly difficult one in terms of calibrating policy actions, given the high uncertainty associated with the global economy and policy responses. On balance, we expect the MPC to opt for a 25 basis points (one basis point is a hundredth of one percent) repo rate hike from the present 6.5%. The reasons are as follows.

Globally, central banks now face a difficult balancing act. Most G-10 central banks have moderated the pace of rate increases to the conventional 25 bps (barring the European Central Bank, which started tightening late), and have changed their forward guidance on policy tightening away from automatic increases to becoming more “data dependent”. For instance, the US Federal Reserve changed its guidance in its March Open Market Committee meeting from the “ongoing increases (appropriate)” over the past several reviews, to “closely monitoring incoming data”.

One hopes that the risk of ongoing “financial accidents” in developed markets has receded. Yet, the continuing policy rate increases, despite concerns of latent financial sector instability, show that, as yet, central banks cannot afford to take their eyes off the inflation ball, even though the effects on the broader economic domain remain shrouded in uncertainty. They are using specific policy instruments to target different objectives, as economic theory would suggest.

The objective of cooling inflation is best achieved through transmission of higher interest rates to borrowers, even while the use of various liquidity and credit support measures by central banks, regulators and governments helps stabilize banking sector fragility. Moreover, tighter credit conditions due to the rise in bond yield spreads and reduced loan availability to SMEs are likely to “weigh on economic activity, hiring and inflation”. In other words, the uncertainty about the banking sector has partially done the central banks’ job, affording them the option of smaller rate hikes and lower peak rates.

How will all this affect India, both in terms of growth momentum and policy responses? Revisions of economic forecasts by RBI, particularly of growth and inflation, will be a strong signal on the future trajectory of policy response. RBI recently assessed that the economy remains resilient, with “a steady gathering of momentum since the second quarter” of FY23. High frequency economic indicators, while moderating, remain robust. The services sector remains particularly strong, in both domestic and export markets. Probably as a reflection of this, core inflation remains uncomfortably persistent, with the number of core inflation components above 6% still above 57% of the total. Yet anecdotal evidence and conversation with automobile dealers and builders are beginning to suggest a slowdown in demand in certain segments, particularly affordable housing and lower-cost passenger vehicles. Despite moderating input costs, working capital loan cycles are getting elongated and utilization of lines rising, a sign of delays in receivables.

On the other hand, RBI data shows India’s banking sector, in fact, the broader financial system, remains sound. Banks have stable, largely deposit-based funding, ample liquidity, little or no exposure to startups, and asset books have large high-quality liquid assets. As of September FY23, scheduled commercial banks and non-banking financial companies were highly capitalized, with low asset stress (net NPA at 1.3%).

Given this balance between inflation, growth and risk of financial sector instability, a 25-bps repo rate hike is probably the likely outcome, with some MPC members continuing to vote for a pause. A smaller, non-conventional increase also remains a possibility, although the signalling benefits of this are weak. One benefit of G-10 central banks approaching their peak rates is that global financial conditions will ease further, reducing depreciation pressures on the rupee, thereby attenuating the need to embed a currency defence component in the interest rate. If an inflection point in India’s current interest rate cycle is judged approaching, the forward guidance of policy, too, is likely to change. The MPC is unlikely to retain its stance “focused on removal of accommodation” and, instead, become more flexible and data-dependent. It is unlikely that the stance will shift straightaway to “neutral”, given that even an expected peak repo rate at 6.75% might be insufficiently restrictive to steadily guide CPI inflation down to the target of 4% over, say, the next two years. Other than the MPC’s rate actions, RBI’s management of system liquidity, which is likely to become structurally zero, or even deficit sometime in FY24, will play a significant role in guiding market interest rates and, hence, transmission of cost of funds for borrowers.

The author is executive vice-president and chief economist at Axis Bank. Views are personal .

Catch all the Business News, Market News, Breaking News Events and Latest News Updates on Live Mint.
Download The Mint News App to get Daily Market Updates.

More
Less

#MPC #hike #repo #rate #bps #quell #inflation

Related Articles

LEAVE A REPLY

Please enter your comment!
Please enter your name here

Latest Articles