The Monetary Policy Committee (MPC) of the Reserve Bank of India has decided to Increase the policy repo rate under the liquidity adjustment facility (LAF) by 50 basis points to 5.40 per cent with immediate effect and accordingly, the standing deposit facility (SDF) rate has been adjusted to 5.15 per cent and the marginal standing facility (MSF) rate and the Bank Rate to 5.65 per cent at its meeting held on August 5, 2022. In view of the uncertainties prevailing in the global and domestic economy, the MPC also decided to focus on withdrawal of accommodation in order to contain inflation within the target limits of plus minus four percent in the medium term, while still supporting growth.
The RBI has taken this decision in the light of several factors affecting the global and domestic economic environment.
Global economic and financial markets remain volatile
Tightening of monetary policy across the world coupled with persisting war in Europe have heightened the risk of recession in the global economy. Guided by risk aversion strategies, the financial markets showed great amount of volatility and large sell-offs. This led to the strengthening of the US dollar against currencies of most advanced and emerging economies. In particular, the emerging market economies are faced with enhanced risks to their growth and financial stability on account of massive increase in capital outflows and reserve losses.
Domestic economic activity considered as resilient
Monsoon rainfall is above its long period average. There are signs of improvement of activity in agricultural, industrial and services sector. While there is an uptick in the urban and rural demand in the domestic economy, there is a record growth of 24.5 per cent in merchandise exports during April-June 2022, though it moderated a bit in the month of July. Besides, an increase in the non-oil non-gold imports is also indicative of strengthening of domestic demand. This is also supported by system liquidity being in surplus, a 7.9 percent rise in Money supply (M3) and a 14.0 percent rise (y-o-y) in bank credit from commercial banks as on July 15, 2022. India’s foreign exchange reserves at US$ 573.9 billion as on July 29, 2022 is also quite impressive.
Inflation remains a top-most concern
Even as the CPI inflation moderated to 7.0 per cent (year-on-year basis) during May-June 2022 from 7.8 per cent in April, it remains above the upper tolerance band of four plus two per cent. Good thing is that the food inflation has eased out on account of decrease in the prices of edible oil, pulses and eggs. However, there was no respite in fuel inflation which moved back to double digits in June mainly on account of upsurge the in LPG and kerosene prices. Despite a cut in excise duties on petrol and diesel pump prices, effected on May 22, 2022, it remains at elevated levels.
Uncertainties cloud the outlook for the near term
Uncertainties about the peaceful resolution of the war between Russia and Ukraine is have caused a sense of uncertainty to the inflation trajectory. Recently food, metal and even oil prices have shown declining trends but they still remain elevated and volatile as supply concerns persist even as the global demand outlook is weakening. Besides the strengthening of US dollar will impact the net importers of commodities and we face the wrath of rising import bills adding up to inflation pressures. Rising import costs and the increasing commodity prices in the domestic economy have pulled up the inflationary pressures across manufacturing and services sectors. Rising kharif sowing augurs well for the domestic food price outlook. These pressures are going to be transferred on to the consumers in terms of rising prices of products and services. However, since monsoons are expected to be normal, there is a possibility that food inflation may ease out in the coming period. The Reserve Bank also considers that the oil prices may average around US $105 and projects that inflation may remain around 6.7 percent in the financial year 2022-23 even as it may show a persistently declining trend every next quarter. (Chart 1)
Strengthening of consumer demand may support growth
The Reserve Bank of India projects that the rural consumption may get a boost due to better prospects for growth in agricultural sector. Further, as the pandemic impact is dissipating, the demand for contact-intensive services coupled with the improvement in business and consumer sentiment may also strengthen discretionary spending and urban consumption. Besides, the increase in government expenditure on capex may improve investment and capacity utilization in the manufacturing sector. Thus, the production volumes and new orders are projected to increase in the coming quarters. Considering all positive and not so positive factors into consideration, the RBI projects that the real GDP growth for 2022-23 will be retained at 7.2 per cent, though it may slow down a bit in the succeeding quarters. The GDP growth for the first quarter of the financial year 2023-24 is projected at 6.7 per cent (Chart 2).
In a nutshell, the central banks across the world are trying to do whatever best they can but they may still be constrained to contain inflation within the target range largely because it is occurring due to extraneous factors resulting from the geo political issues.
Hence, the central banks may also have to take a call as to reset their targets which seem achievable under the unusual circumstances and give the governments the fiscal space to cope up with development, welfare and environmental issues which are also so much crucial for the upkeep and maintenance of financial stability.
Raising of interest rate is not a panacea for all types of inflationary pressures. A combination of measures at intra policy and inter-policy level articulated carefully to suit peculiar circumstance faced by each country coupled with diplomatic endeavors to find a peaceful solution to the present geo-political issues could be more effective. The focus should be on treating the cause rather than the symptoms as at the end of the day you need a long term and stable social, political and economic environment.