MPC must serve one last rate hike without being too hawkish

As the six-member rate-setting committee of the Reserve Bank of India, the monetary policy committee (MPC), is huddled together to vote on policy rates, economist Thomas Sowell’s phrase "there are no solutions, only trade-offs" should make for a necessary post-script.

The RBI’s primary responsibility is to minimise the trade-offs involved in keeping interest rates that foster growth without igniting inflation. However, here is where the problem is intense for the RBI. The MPC is already showing divergent views on what this level of policy rate should be.

The three-day MPC meeting commenced on December 5 and the RBI will come out with its next bi-monthly policy review on December 7.

The repo rate is at 5.90 percent, and most economists reckon that it should be 6.25 percent, at which point inflationary pressures would be contained without economic growth getting hurt by much.

The RBI has already hiked the key policy rate by 150 basis points since May to 5.9 percent to cool off domestic retail inflation.

Arguments for a pause

Two members believe that the economy has already reached the neutral level of interest rate at which growth would flourish without inflation flaring up.

Jayant Varma and Ashima Goyal believe a pause is warranted now, even though the repo rate is sub-6 percent and inflation for FY23 is expected to be 70 basis points above it, according to the RBI’s projections.

One basis point is one-hundredth of a percentage point.

Varma’s argument is that taking the expectation of retail inflation falling to about 5 percent a year ahead, the current repo rate would bring real effective interest rates into the positive territory.

Anything higher than the current level could start to impinge on the nascent revival in the investment cycle as private producers would find it restrictive to build capacity.

In other words, the RBI may end up sacrificing a bigger chunk of growth to curb inflation, which is anyway on a downward path. That said, the trade-off between inflation and growth at 6.25 percent of repo rate is not as high as it seems to be.

Also read: Monetary Policy Committee meeting: the message from the bond markets

Why some believe a hike is needed

This brings us to the arguments that support a hike in the repo rate, something that the RBI representatives in the MPC seem to believe in.

The repo rate is at 5.90 percent and some economists reckon that it should be 6.25 percent at which point inflationary pressures would be contained without economic growth getting hurt by much.

There is merit in this argument. Recall that despite a massive 150 bps increase in the effective interest rate through repo rate increases and liquidity withdrawal, the 10-year corporate bond yield has only climbed 60 bps in the past nine months.

Bank loan rates have increased by a faster 110 bps but the surging credit growth shows price is not hurting demand. A 25-35 bps hike in the repo rate may not move the needle too much for borrowers.

Also read: Cooling prices give RBI space to slow interest-rate hikes

Global factors

What can be more damaging for the private investment cycle revival are global influences that are out of the RBI’s control.

The US Federal Reserve is expected to hike its fund rate by another 50 bps in the next meeting. The magnitude of the hike is, of course, smaller than the previous ones and could be one of the last by the Fed.

Global markets are already pricing in a Fed pivot to a softer tone and bond yields are softening. Even so, for emerging markets such as India to continue to attract capital would require a reasonable mark-up to US assets. In other words, the interest rate differential or returns must justify the investment.

Also read: Banking Central | What will be the MPC meet outcome on Wednesday?

With the gap between Indian and US rates at a decade-low, attracting capital becomes a challenge. Granted, foreign investors are already turning bullish on India (the recent turn in foreign fund inflows reflects this). But flows are fickle and all it takes is a geopolitical event to swing the sentiment away from us.

Protecting the domestic market from external headwinds, thus, falls on the RBI. Economists at HSBC point out that a higher trade deficit and core inflation warrant a repo rate of 6.5 percent.

The MPC has a tool that can soften the blow of an interest rate hike, which is the policy stance. Most economists believe that the stance would change from withdrawing accommodation to a neutral one.

“In addition, given our assessment that the policy rate is now closer to neutral (and positive on an ex-ante basis), this should also be the time for the MPC to shift its policy stance to neutral,” wrote economists at Barclays in a recent note.

A softer commentary won’t look odd, especially when global inflation is turning and the outlook for domestic retail inflation is benign for the next one year. Given that markets have largely priced in a rate hike, a central bank comfortable with the inflation trajectory would give markets some succor.On the other hand, a pause delivered with a message that indicates hikes ahead is only going to agitate markets. Markets, above everything else, hate uncertainty. An uncertain interest rate direction added to the stew of uncertain global commodity prices, and uncertain inflation would do long- lasting harm.