Monetary policy is starting to bite

During the period May - December 2022, the Monetary Policy Committee (MPC) has increased the policy repo rate (PRR) under the liquidity adjustment facility (LAF) cumulatively by 225 basis points to take the PRR to 6.25 per cent. This steep increase was warranted as the inflation rate crossed the upper band of tolerance of 6 per cent. The RBI Governor has offered three reasons for the repo rate increase at the latest meeting of the MPC in Dec. 2022: (a) to keep inflation expectations anchored, (b) to break core inflation persistence, and (c) to contain the second-round effects.

We may still be the fastest growing economy but that wind in the hair may cease

Meanwhile, unanimity of MPC members on rake hikes has given way to some disagreements on the way forward. While the members were unanimous in their voting for a rate increase and continuation of the accommodative stance in May 2022, opposition from among the MPC to rate increases and withdrawal of the accommodative stance showed up in subsequent meetings. The views against the end of the accommodative stance by two members in the December 2022 resolution is a pointer to the scepticism by these members on continued tightening with roll-on effects on growth.

In view of the above, the question on how much to tighten, and fears of slaying growth rather than inflation (fears which are commonly raised by business in the Indian context), acquire a new significance. At this time, of course, overtightening of monetary policy is seen as a global concern. The US Fed has continued tightening. On Nov. 2, 2022, the Fed decided to raise the target range for the federal funds rate by a jumbo 75 basis points to 3-3/4 to 4 percent, the highest since 2008 and the fourth consecutive jump. In a statement, the Fed noted: “The Committee anticipates that ongoing increases in the target range will be appropriate in order to attain a stance of monetary policy that is sufficiently restrictive to return inflation to two per cent over time.” And the IMF in its World Economic Outlook, December 2022, remarked: “Central banks around the world are now laser- focussed on restoring price stability and the pace of tightening has accelerated sharply ……. Overtightening risks pushing the global economy in to an unnecessarily harsh recession.”

The move towards a higher growth trajectory has weakened, thanks to rising lending rates

In the Indian context, it is important to note that both headline and core (excluding the sensitive items like food and fuel) inflation remain a policy concern as these two have been ruling at more than 6 per cent. According to the RBI governor, core inflation is “high and sticky” and continues to be a “pressure point”.  What has been inflation-growth dynamic during the tightening phase of monetary policy? It is important to mention that for three consecutive times (June, August and September 2022), the MPC has increased the policy rate by 50 basis points each time, taking the total to 150 basis points. Such increases clearly indicate a harsh tightening.

We may add that while the inflation forecast for 2022-23 has been kept at 6.7 per cent in the five bi-monthly MPC resolutions (May, June, August, September and December), the growth forecast has been revised downwards from 7.2 per cent in June 2022 to 7 per cent in September 2022 and further to 6.8 per cent in December 2022.  In the December 07, 2022 resolution, the MPC has projected that in 2022-23, the headline inflation is expected to be at 6.7 per cent but will moderate in H1 of 2023-24 (5.0 per cent in Q1 and 5.4 per cent in Q2).  As regards the growth outlook, the MPC resolution on December 07, 2022 has projected that while the growth will be at 6.8 per cent in 2022-23, the growth rate for will be at 7.1 per cent in Q1 but it will decelerate to 5.9 per cent in Q2.

Given the higher component of dis-savings by the government in terms of revenue deficit coupled with absence of fiscal space with the government and the binding borrowing constraints due to higher interest rates because of policy tightening, there could be pressure on the government to lower the allocation of capital expenditure in order to adhere to the medium-term target prescribed in the FRBM ACT 2008

The projections reflect the expected adverse impact on growth of tightening monetary policy. The full impact of the overtightening is yet to come as there are time lags in the monetary policy transmission mechanism. However, as it was pointed out by the RBI Governor, during the current tightening phase beginning May 2022, the weighted average lending rates on fresh and outstanding rupee loans have increased by 117 basis points and 63 basis points, respectively.

Industry-wise credit deployment of gross bank credit as an indicator of private sector reaction to monetary policy tightening in terms of rate increases points to other impacts. According to the latest data release by RBI (Weekly Statistical Supplement dated December 09, 2022), the marginal cost lending rate (MCLR) overnight has increased to within a range of 7.25 and 8.15 per cent as on December 02, 2022 as against as against the range of 6.50 and 7.0 per cent a year ago. During the same period, the policy rate was increased from 4.0 per cent to 5.90 per cent, an increase of 190 basis points. The credit deployment has been at a lower order during the financial year so far up to September 23, 2022, examples of this being large industries (1.4 per cent), commercial real estate (2.2 per cent), priority sector housing (1.3 per cent), export credit (-33.2 per cent) and social infrastructure (-2.8 per cent).

Overtightening of monetary policy is seen as a global concern

Against the above backdrop, important questions are: (a) how long will the tightening monetary policy phase continue? (b) will the external sector support growth in terms of a higher Current Account Deficit (CAD) and financing of the same in a non-disruptive manner? and (c) to what extent will fiscal policy support growth in terms of higher allocations in respect of capital expenditure?

In the RBI’s own admission, as outlined at the Governor’s press conference of Dec 07, 2022, the worst phase of inflation is over and there will be no further hike of the quantum of 50 basis points hereon in this phase. The market expects that there could be one more hike of 25 basis points in February 2023 and MPC may close the tightening cycle with the policy repo rate at 6.5 per cent.

The market expects that there could be one more hike of 25 basis points in February 2023 and MPC may close the tightening cycle with the policy repo rate at 6.5 per cent

Historically, India’s growth was supported by domestic savings and domestic investment. But given the higher component of dis-savings by the government in terms of revenue deficit coupled with absence of fiscal space with the government and the binding borrowing constraints due to higher interest rates because of policy tightening, there could be pressure on the government to lower the allocation of capital expenditure in order to adhere to the medium-term target prescribed in the FRBM ACT 2008. Financing the CAD in a non-disruptive manner implies that there should be more greenfield FDI flows in our hierarchy of capital flows. However, as the global economic situation could turn to a downward trajectory (as there is a fear of recession as mentioned in the IMF’s World Economic outlook December 2022), the flow of investment funds looks difficult.

To conclude, overtightening of the monetary policy has further weakened the move towards a higher growth trajectory. We may still be the fastest growing economy but that wind in the hair may cease.  It only serves to remind us that there are costs to achieving ends, and sometimes the costs can become more than we can afford.

(The writer is a former central banker. Views are personal)

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