Caught in a Catch-22 Situation
The Monetary Policy Committee’s (MPC) decision to hike the repo rate by another 50 basis points to 4.90 per cent after a surprise 40 basis points hike last month comes as no surprise. With expectation becoming reality, the markets moved higher, but only for a short while. After a short while, bears once again took over the baton as a result of which the Nifty 50 index extended its fall for the fourth straight session on Wednesday. The MPC has come around to the view that inflation is proving to be in much more dire straits than it had visualised just a couple of months back. We believe that the MPC has taken the right path by hiking the repo rate after May, indicating its intent to snuff out inflation.
Moreover, after more than two years it has finally set aside the ‘accommodative stance’. Also, the MPC has further raised its CPI inflation for 2022-23 from 5.7 per cent announced in its April meeting to 6.7 per cent now. The MPC has reassessed the situation and as a result of this late realisation, the first two rate hikes of the current cycle have been rather steep. Interestingly, the markets had already priced in a rate hike of higher quantum as the RBI governor earlier had signalled that rate increase is a ‘no brainer’ in his interview. Thus, during the current policy, the 10-year yield was broadly stable between 7.47-7.5 per cent.
However, we expect India’s 10-year yield to remain elevated in the range of 7.75-8 per cent as the RBI moves towards calibrated withdrawal of liquidity. Now, the question to ask is this: is the RBI using a sledgehammer against inflation, unmindful that it may well stall all possibilities of economic growth? Interest rates – the key instrument in the monetary policy tool kit – are hypothetically supposed to work by quelling demand. And, since price stability is the key objective of not just the RBI but most central banks, the instrument’s effectiveness rests on the perception that the economy is ‘overheated’.
According to this logic, since surging demand, relative to supply, is the primary cause of inflation, curtailingdemand through a reduction in the pace of economic activity via an increase in interest rates would keep prices in check. However, this logic, does not sit well with the empirical reality in India. As the latest GDP data points out, India is indeed going through muted private consumption demand. The fact is that inflation is driven by supply side, ‘imported’ factors. There is one question that needs to be answered: despite the recent efforts taken by government and the RBI, what happens if inflation does not show signs of cooling off.
In that case, RBI would have no alternative but to continue with excessively sharp hikes and these would quell the already weak prospect of an early economic recovery. It’s an issue worth keeping in mind. The RBI has to walk a hard tightrope between controlling inflation through various means and not unduly sacrificing growth. The list of problems does not end here. The runaway rupee is the next worry. The central bank has once again been found in the position of defending the Indian rupee by intervening in the forex market, in the process risking depletion of its foreign exchange reserves.
With the Russia-Ukraine war showing no sign of abating and the Iran nuclear deal getting delayed, most estimates suggests that crude, which is on the boil, would continue to stay at an elevated level. This implies that India’s trade deficit is likely to persist and continued supply disruption in global metals, chemical and agriculture commodities, due to the ongoing war, could add to the import bill. In short, the RBI is in a Catch-22 situation for the time being. Technically, on the daily chart of the index we have seen the formation of a bullish candle that has managed to close near its day high. However, it has failed to cross above its prior day high and this could be viewed as a relief rally amid weekly options’ contract expiry. Overall, the level of 16,100 is an important support level in the near term. Hence, watch this level closely.
