The forthcoming review of the Monetary Policy Committee (MPC) is likely to take the political focus that began in early April, the MPC review, and then reinforced at the surprising off-cycle meeting in early May. Several scenarios for the path of the monetary policy response, using a combination of economic forecasts and market signals, are discussed by analysts and markets.
This article aims to supplement these arguments by drawing on a number of empirical results from RBI’s own econometric research. These provide a very useful analytical scaffolding that helps to better understand the monetary policy response function by applying the results to new data. In particular, a recent article, written by RBI experts, provides a comprehensive collection of insights from past and ongoing research.
The April MPC statement had indicated the shift in political response priority: (i) inflation control, (ii) maintaining growth and (iii) maintaining stability in the financial sector.
The first RBI result is that inflation beyond the 6% threshold is starting to hurt growth. CPI inflation may average 6.5-6.7% in FY23, remaining above 7% in the first two quarters. This forecast has emerged after taking into account the effect of auto fuel taxes and VAT reductions and a number of fiscal, commercial and industrial measures as part of a coordinated response.
However, it appears that there is still a significant amount of input cost flows, based on an analysis of Q4 financial results for listed companies. Service inflation is likely to increase pressure.
The second result from the RBI workhorse New Keynesian model suggests that market failure creates stickiness in the prices of goods and services and wages. One of the market failures in India is probably the increasing evidence of concentration of purchasing power in the top two to three deciles, which exacerbates this stickiness. The marginal propensity to consume of these deciles is low and their large savings are likely to provide a buffer against high prices. Monetary policy will have to be supplemented by other political instruments.
The third result suggests that a change of 1 percentage point (pp) in the real interest rate gap leads to a change of 0.2 percentage points in the output gap. This means that every 1 pp. Rate hike will only reduce growth by 20 bps, which means that a strong interest rate response may be needed to tame inflation.
The fourth result concerns the second priority, growth. At what point in the rate hike cycle does the sacrifice ratio become negative when the cost of rate hikes outweighs the benefits of anchoring inflation expectations? However, the response should not be so strong that it kills growth, which is formally acknowledged in the fourth result: Recent Taylor Rule weights for India are 1.2 for inflation and 0.5 for growth.
Compare this to the likely trade-offs that the Federal Reserve may be working on, with the growth weight likely to be close to zero. This suggests that the intensity of the RBI rate hike will not reflect that of the Federal Reserve.
The country’s GDP growth may reach 7.1% in FY23. In the short term, high-frequency indicators show strong economic activity. Service indicators also remain strong. Credit withdrawals relating to retail loans indicate that consumer demand remains strong.
Yet there is already evidence that the demand for discretionary procurement has weakened. Wealth effects from the stock markets are likely to decline.
The third priority in the monetary policy response is stability in the financial sector. This time, the transmission in India to the banks’ lending rates will be very fast; interest rate adjustments will happen quickly. More than 70% of loans to MSME and medium-sized companies are now linked to External Benchmark Linked Rates (EBLR, mainly to the repo rate), just as 58% of home loans are. In line with declining growth, the potential stress on weaker borrowers is likely to increase. Short-term market financing rates have already risen by almost 2 percentage points since October 2021 (see graph).
Given the many trade-offs highlighted above and the analytical moorings that are likely to shape the political response, there is a clear need to calibrate interest rate hikes based on incoming economic data.
The second instrument to moderate aggregate demand is the level of excess system liquidity. The fifth RBI result indicates that 1.5% of deposits (NDTL) is the “non-inflationary” level of excess liquidity. Every 1% increase above this leads to an additional 60 bps inflation over the course of a year. 1.5% of NDTL is 2.6 trillion Rs. Current liquidity averages around Rs 3.7 trillion and is likely to return to Rs 4.5 trillion in mid-June due to expected increases in the Center’s expenditure. This is still uncomfortably higher than the stated threshold, which may necessitate a further CRR increase in either the June and August revisions or in between (CRR may be raised any day as this is not an MPC instrument), depending on evolving liquidity conditions. .
The expected rate hikes in the US and some other G-10 central banks are likely to be at a pace not seen in nearly a generation. This will definitely bring surprises. Some of these unintended consequences will spread to new markets, including India. RBI and MPC will have to respond to both global and domestic risks as and when they emerge and evolve.
The author is Executive Vice President and Chief Economist, Axis Bank Views is personal
