The Monetary
Policy Committee (MPC) of the RBI raised the policy repo rate by 40 bps to 4.40
percent in an off-cycle meeting on May 4, 2022. The stance of the MPC remained
accommodative but in the previous two policies (April and May), inflation
concerns have outweighed weakness in economic growth. The broad market consensus
of the February 2022 policy was that the MPC was relatively dovish with
inflation projected to ease from 6 percent in January 2022 to
4.2 percent by the last quarter of FY23. Revival of economic growth also
took centre-stage.
In a span of
three months, tables have reversed and market expects the policy to be
relatively hawkish with the policy repo rate to be hiked by atleast 100 bps by
the end of this fiscal in order to reign in the headline retail number and
anchor inflation expectations. Many analysts also expect the RBI to hike the
repo rate by 50 bps and further tighten the banking system liquidity by 50 bps increase
to the cash reserve ratio (CRR). The CRR
was raised by 50 bps in the off-cycle meeting to flush out the excess
liquidity surplus aggregating Rs 87,000 crs.
The arguments
made so far for rate hikes have been more attuned to retail inflation remaining
above the 6 percent target for a sustained duration, need for anchoring
inflation expectations and lingering global inflationary pressures sapping
consumer sentiments. Contrastingly, there
have been some arguments which conclude that a contractionary monetary
policy response to tackle price escalation due to an oil supply shock may not
be the appropriate response.
Ahead of the MPC meeting scheduled for tomorrow, are we
undermining the sustained weakness in the domestic growth impulses while giving
persistent inflation too much importance? Could an aggressive policy response
by the MPC dampen the nascent growth recovery? Are the present aggregate demand
conditions robust enough to enter a faster rate-hike cycle?
Firstly, the
Indian economy during Q4-FY22 grew by 4.1 percent, the third straight
quarter of decline in GDP growth primarily led by a sharp deceleration in
private consumption expenditure and decline in the growth of gross fixed
capital formation (GFCF). On the supply side, the manufacturing sector reported
disappointing numbers (contraction of 0.2 percent) while the construction
section grew modestly by 2%.
Industrial
output (IIP) also grew by a subdued pace of 1.9 percent in March 2022. The capacity
utilisation has inched above 70 for the first time after 9 consecutive
quarters but is still lower than the decadal pre-pandemic average of 73.
In
a recent report by Nielson IQ, the sales volume of consumer goods fell by
4.1 percent for Q4-FY22 (y-o-y) with a great contraction of 5.3 percent
witnessed in the rural markets. This can be partly ascribed to rising input
cost pass-through by FMCG companies or by reducing the package size and keeping
price unchanged, popularly called as “shrinkflation”.
These
macroeconomic indicators reflect a gloomy as well as uncertain environment with
some signs of improvement. An aggressive bet on policy rates could derail this
recovery.
Secondly, the high
frequency indicators as released in the State of the Economy report by the
RBI shows a mixed picture. The year-on-year growth in passenger vehicle sales
till April 2022 continues to witness a contraction while the growth over the
pre-pandemic month (April 2019) for two-wheeler sales and three-wheeler sales
continues to be negative (30 percent contraction for 2-wheeler sales and 50
percent contraction for 3-wheeler sales in April). Domestic air cargo and
passenger traffic has seen sequential improvement but comparison with
pre-pandemic month (April 2019) is still negative. This is the case with
international air passenger traffic as well. The y-o-y growth in steel consumption
was modest at 1 percent in April 2022 while the growth for cement production is
moderating. The silver lining has been E-way bill collections and the PMI
values for both manufacturing and services.
Lastly, bank
lending has seen a renewed optimism with non-bank food credit growing by 11.3
percent in April 2022 (y-o-y) and this has been broad-based with credit to
industry registering a growth of 8.1 percent, services by 11.1 percent and
personal loans by 14.7 percent. An RBI Working
Paper (2018) concludes that economic activity and non-food credit
positively impacts investment activity while real interest rates and gross
fiscal deficit negatively impact. In one of the previous instances of rate hike
in from 6.25 percent in Dec’2010 to 8.5 percent in Oct’2011, non-bank food
credit decelerated from 27.7 percent to 18.9 percent. There has been a similar
adverse impact on credit growth observed during 2013-14 (another period of rate
hike) as well. With gross fiscal deficit elevated, real interest rates rising
and economic activity in a recovery stage, aggressive rate hikes could
adversely impact the non-bank credit channel, which could indirectly have a
bearing on the investment activity and economic growth.
Till the
February 2022 MPC meeting, the revival and durability of economic growth was of
paramount importance with inflation taking back seat. The macroeconomic
environment has definitely changed in a short span and raising policy rates is
inevitable in the June 2022 meeting. However, the weightage assigned to
economic growth in the popularly Taylor rule (econometric model that describes
the relationship between nominal interest rates, inflation, economic growth)
should not change much. Aggressive monetary and fiscal policy action to supply-side
led inflation pressures could significantly derail India’s economic growth
recovery.
