Growth will have to be sacrificed
In an off- cycle meeting on 2nd and 4th May 2022, the Monetary Policy Committee (MPC) increased the policy repo rate (PRR) to 4.40 per cent, a jump of 40 basis points. Simultaneously, the RBI also increased the cash reserve ratio (CRR) by 50 basis points to 5.0 per cent of net demand and time liabilities (NDTL), effective from the fortnight beginning May 21, 2022 The two-pronged actions were intended to fight inflation both in terms of the quantity channel (arresting liquidity and there by money stock) and the price channel (interest rate increase by increasing PRR). The hike in CRR according to the RBI would pullout liquidity to the tune of Rs.87,000 crore.
RBI’s hawkish policy stance is bound to hit growth and adversely impact the employment situation
The market was expecting a PRR hike as retail inflation has been high, crossing the upper band of the flexible inflation target (FIT) of 6 per cent for three consecutive months, beginning January 2022. Besides, there was a fear of imported inflation as inflation the world over is up. According to IMF (April 27, 2022 World Economic Outlook), the inflation rate measured in terms of CPI would be 5.7 per cent for advance economies and 8.7 per cent in emerging market and developing economies (EMDE). Many of the Central Banks have also hiked the policy rates to meet the challenges of inflation.
However, what surprised the market was the sudden announcement of the rate hike against the back drop of the April 08 inflation forecast of 5.7 percent which is lower than the upper band of 6 per cent. It may be mentioned that as the inflation rate increased to 8.7 per cent in the US the Fed Reserve, Federal Open Market Committee increased the target range for the federal funds rate to 3/4 to 1 per cent on May 04, 2022.
Another surprise for the market is an increase in CRR. The RBI went for a CRR increase because of the dominance of ample system-level surplus liquidity, resulting in a large liquidity overhang. This liquidity overhang had resulted in the weighted average call money rate (the operating target of the monetary policy) moving below the standing deposit facility rate (which is the floor in the LAF corridor to absorb liquidity).
The RBI went for a CRR increase because of the dominance of ample system-level surplus liquidity, resulting in a large liquidity overhang.
Since the introduction of SDF on April 08, 2022 till date, the WACR has been in the range of 3.43 per cent and 3.67 per cent as against the SDF rate of 3.75 per cent, indicating ample liquidity surplus at the system level. It may, however, be mentioned that the WACR rate was also lower than the overnight reverse repo (ORR) rate before the introduction of SDF. But the difference between the two instruments is that ORR is absorption of liquidity with collateral and functioned at the discretion of the RBI whereas SDF is designed to be absorption of liquidity without collateral and is at the discretion of the banks, making it open ended as the constrain of collateral is dispensed with.
The impact of surplus liquidity on inflation was analysed in the Report on Currency and Finance released by the RBI on April 29, 2022. The report states that net LAF surplus of more than 1.52 per cent of NDTL could be inflationary. The surplus liquidity during the period April 8- April 29 as measured in terms of absorption through SDF and variable rate reverse repo (VRRR) auctions amounted to Rs. 7.5 lakh crore.
Furthermore, one percentage point exogenous increase in surplus liquidity above this threshold value of 1.52 per cent of NDTL could push up inflation by 60 bps on an average in a year. The report recommended that large surplus liquidity overhang has to be withdrawn and monetary policy has to assign priority to price stability as the nominal anchor for a growth trajectory.
Further policy rate hikes in the next meeting of the MPC on June 6-8 2022 may not be ruled out as upside risks seems to continue because of geo political and global commodity price risks. Besides, core inflation (headline CPI inflation minus food and fuel) has been persisting at a higher level of around 6 per cent.
The surplus liquidity could be due to an increase in net RBI credit to government and/or on account of an increase in net foreign currency assets. Recently, there has been an increase of liquidity due to increase in net RBI credit to the Central Government to the tune of Rs. 1.65 lakh crore on a financial year basis, as on April 22, 2022, whereas the net foreign currency assets declined by Rs. 1.15 lakh crore on the same date. The increase in net RBI credit to government could be on account of large monetary accommodation to the government in terms of Ways and Means Advances (WMA). It may be noted that daily data on WMA is not available in the public domain. The limits of WMA are arbitrarily fixed by the RBI and government whereas the WMA limits for the State governments are formula-based, linking this to budgetary transactions. For example, the WMA limits for the Central government during H1 of 2022-23 has been fixed at Rs 1.5 lakh crore. It is appropriate that the RBI and government should make the WMA limit formula-based along the lines of the State governments.
The increase in the policy repo rate “may be seen as a reversal of the rate action of May 22, 2020, in keeping with the announced stance of withdrawal of accommodation set out in April 2022”, as the RBI Governor put it. On May 22, 2020 there was a reduction of 40 basis points, which the RBI said was “ultra-accommodation”. Prior to May 22, 2020, the MPC also reduced the policy repo rate by 75 basis points as a part of ultra-accommodation on March 27, 2020. Even though in letter, the MPC claims that its stance remains accommodative in spirit, the stance is tightening. Thus, further policy rate hikes in the next meeting of the MPC on June 6-8 2022 may not be ruled out as upside risks seems to continue because of geo political and global commodity price risks.
In the interest of inflation management, which is the overarching policy need at the current juncture, growth will be sacrificed.
Besides, core inflation (headline CPI inflation minus food and fuel) has been persisting at a higher level of around 6 per cent. The current hike of PRR and possibility of a future increase of PRR could impact the growth-inflation dynamics as the economy will move in the disinflation glide path. The MPC has not set out any growth or inflation outlook. However, the inflation rate in coming months will continue to be higher than the upper band of 6 percent. At the same time, real GDP will be lower than the RBI estimate of 7.2 percent in 2022-23.
The reduction in the growth rate will adversely impact the employment situation. The RBI’s credit and finance report has empirically examined the co-movement of growth and unemployment in the conceptual framework of the celebrated Okun’s Law (Okun’s Law in the context of USA states that for every 2 per cent that GDP falls relative to potential GDP, the unemployment rate rises about 1 per cent point) for India. The data on unemployment rate and real GDP growth from 1980-81 to 2019-20 suggests that a decline in GDP growth by one percentage point increases the unemployment rate by around 0.13 percentage points.
Given the so-called tightening stance to withdraw the ultra-accommodation by a hike in PRR coupled with a CRR increase, it is doubtful whether the RBI will remain in the FIT target and at the same time support growth. In the interest of inflation management, which is the overarching policy need at the current juncture, growth will be sacrificed.
(The writer is a former central banker and a faculty member at SPJIMR. Views are personal)