An interest rate increase per se wouldn’t have been shocking given the price pressures that have been building up and the actions of other central bankers in the past few months, because data were pointing to the build-up of a storm. But a rate action in an unscheduled meeting after following a different narrative raises more questions than it answers.
After bingeing on liquidity for more than two years even as the real economy struggled with millions losing livelihood, financial markets began looking for signals from central banks on when they would take away the punch bowl.
Central banks initially saw supply disruptions caused by the Covid pandemic driving prices. Then it shifted to shortage of semiconductor chips. Then, the capacity constraints that came because of holding up of investments due to the Environmental, Society and Governance or ESG standards. Then came the sanctions on Russia – and now it’s generalised.
“The risks of unprecedented input cost pressures translating into yet another round of price increases for processed food, non-food manufactured products and services are now more potent than before. This could strengthen corporate pricing power if margins get squeezed inordinately,” said Governor Shaktikanta Das.
While the likes of the US Federal Reserve and the Bank of England signalled reversal from easy policy late last year, India, that lost the most in output due to Covid, remained accommodative and kept rates despite some economists expecting a hike as early as February.
“The whole character of inflation is very different in the US, for instance, than from ours,” deputy governor Michael Patra said on February 10. “For instance, one thing that is driving up US inflation is used cars. Now, that is not the basis for our inflation, nor are we importing used cars from the US. Back in Europe, the issue is truck drivers and that is also something we don’t import.”
While that convinced the markets that the approach would be different and the tightening is a bit far as the MPC still put growth ahead of inflation.
Governor Das who has been focusing on forward guidance comforted the market. “As stated by me earlier, our actions will be calibrated and well-telegraphed,” Das said on February 10.
Apart from raising rates on Wednesday, the RBI lifted the Cash Reserve Ratio, the proportion of deposits that banks keeps with RBI, by 50 basis points to 4.5%. That dealt a blow.
“The RBI will engage in a gradual and calibrated withdrawal of this liquidity over a multi-year time frame in a non-disruptive manner beginning this year,” Governor said last month after putting inflation ahead of growth.
In the minutes of the MPC meet, independent member JR Varma raised the issue of communications. “It is important to maintain the credibility of monetary policy communications, and deviation from prior forward guidance should be made only under truly exceptional circumstances,” Varma had said.
Both the rate hike and reserve requirement increase in an unscheduled MPC meet after the commentary last month makes the market believe that the nature of inflation may be a lot worse than being pencilled in now.
Fast developing events may have forced the MPC to do a rethink on its actions, but Governor Das is giving a sneak peek into what’s in store.
“It may be recalled that in response to the pandemic, monetary policy had shifted gears to an ultra-accommodative mode, with a large reduction of 75 basis points in the policy repo rate on March 27, 2020 followed by another reduction of 40 basis points on May 22, 2020. Accordingly, the decision of the MPC today to raise the policy repo rate by 40 basis points to 4.40% may be seen as a reversal of the rate action of May 22, 2020.”
Is the reversal of the March 2020 decision the next step? A 75 basis point increase, perhaps?