In a boxing bout, if the opponent is on the verge of collapsing, his corner can save him by throwing a towel into the boxing ring. In its fight against surging inflation, the MPC threw in the towel today by announcing an off-cycle 40 bps policy rate hike. All members of the RBI’s MPC unanimously voted to increase the policy rate by 40 bps to 4.4% and remain accommodative while focusing on withdrawal of accommodation to ensure that inflation remains within the target range going forward, while supporting growth.
Consequently, the standing deposit facility (SDF) rate stands adjusted to 4.15%, and the marginal standing facility (MSF) rate and the Bank Rate to 4.65%. MPC also decided to increase the cash reserve ratio (CRR) by 50 bps to 4.5% of net demand and time liabilities (NDTL) effective May 21, 2022.
Our Views
The market was expecting a 25 bps rate hike in the June meeting but wasn’t really ready to absorb today’s move. As a result, both equity and bond markets saw a major knee-jerk reaction. Equities registered a ~2% sell-off whereas the 10-year benchmark G-sec yield moved up by 28 bps post announcement, trading at 7.38%. Year-to-date yields are up ~1%, largely driven by the surge in US Treasury yields, a spike in crude oil price, and G-sec supply pressure.
Why today’s move came in as a shock? What has changed from the April setting to date?
Short answer – nothing material. Global commodities have more or less been stable last month. Brent crude oil is trading at $108 per barrel and was at $106 around the start of April. Industrial metals are down around 5% from the levels seen in early April. However, concerns that elevated inflation levels might persist longer than anticipated and its negative impact on growth and financial stability led to today’s move – March CPI came in at 6.95% with food inflation picking up and April CPI is expected to move higher. Also, in hindsight, RBI may not be fully cognizant of the inflation trajectory and repeatedly made upward revisions to their inflation estimate. A segment of the market did view this as being ‘behind the curve’, when RBI didn’t change its policy stance and maintained status quo during the April meeting.
In the April meeting, the focus had shifted from growth to inflation on the back of geopolitical events and the resultant spike in commodity prices. The improving domestic growth trajectory also gave some comfort to shift the focus on inflation. High-frequency indicators are seeing improvement with urban and rural consumption demand inching up slightly above pre-pandemic levels. Indian manufacturers signaled an increase in new orders and output with April manufacturing PMI coming in at 54.7 compared to 54 in March. Both direct and indirect tax collection numbers continue to show strong growth with GST collection for April standing at a record high of Rs 1.68 trillion. Credit offtake shows some improvement with non-food bank credit registering 9.7% y-o-y growth in March 2022 vs 4.5% a year ago.
In the near term, the ongoing global geopolitical tension could impact global recovery and have a spillover impact on India. Global supply disruptions and surge in various commodity prices could dampen consumption demand in the near term. This clubbed with a reversal in monetary policy - moving to rate hikes & other tightening measures- by major central banks pose downside risks to the growth. Crude oil prices above $100 per barrel is a significant risk for an oil-importing country like India and can have both direct and indirect (pass-through) impact at ground level. The direct pass-through of high oil prices to retail consumers will start hurting discretionary consumption. The indirect effects such as a rise in transportation costs fueling an increase in prices of goods and services is also expected to play out in the near term.
On currency, lately, RBI has been intervening in the forex market to support the Rupee and RBI may continue to do so in the near term. If they don’t and let the market determine a fair INR/USD rate – INR could depreciate further from here, a positive for exporters. However, it will increase the import bill given that we’re a net importing nation and could further strain inflation – not a comfortable situation to be in at the moment where FPI outflow is putting further pressure on Rupee. Today’s move right before the U.S. Fed’s rate hike announcement is also viewed as an indirect measure to support Rupee in real terms.
In the April setting, RBI made it explicitly clear that the objective is to remove the excess surplus liquidity from the banking system while allowing sufficient liquidity in the system to support credit offtake. In line with that, the MPC decided to increase the cash reserve ratio by 50 bps to 4.5%. The withdrawal of liquidity through this increase in the CRR would be around Rs 87,000 crores immediately once the higher rate becomes effective.
The recent surge in yields may create some pain for investors who have entered the debt market in the last twelve months. However, the current levels do offer an attractive real (inflation-adjusted) term spread in the medium-long term segment i.e. 5-10 years maturity (~3.3%) and is above the long-term historical average of 1.5% – improving its relative attractiveness over short-term debt and cash where the real rates are negative.
Today’s move officially marks the beginning of the interest rate hike cycle. It is likely that the MPC will go multiple rate hikes in the upcoming meetings. To RBI’s credibility, the governor threw in the towel before it’s too late, giving economic activity time to recover to pre-pandemic levels supported by ultra-loose monetary policy.
