Beat inflation: RBI may have to kill demand, hike rate, suck liquidity
With inflation seen as the “biggest threat” to the economy, the Reserve Bank of India (RBI) is considering reversing all measures – liquidity injections and policy rate cuts – taken during the pandemic over the past 1 to next 2 years, a source with knowledge of the development said. The consumer price index or CPI-based inflation exceeded 6% for three consecutive months from January to March 2022 and is expected to cross the 7% mark in April.
Most of the inflation risks emerge from the crisis caused by the war between Ukraine and Russia. “Three-quarters of the CPI is due to war risk… Supply-side constraints have worsened and we are compelled to act. Over the next 6-8 months, we will reduce inflation by suppressing any demand; it will happen all over the world. All central banks, including RBI, are going to lead their economies to lower demand,” said the source, who did not wish to be named.
“Pandemic measures will inevitably be reversed. It may take a year or two years. Rs 5 lakh crore of pandemic measures expired in 2021-22…there are sunset dates for each. Interest rate cuts over the past two years were also pandemic-related measures aimed at helping individuals and small businesses in an emergency. They must be removed or there is a moral hazard of financial instability,” the source said.
The central bank hoped to withdraw them on a deferred basis as the economy was still recovering. “But now higher than expected inflation is upon us. We are not making extraordinary hikes, but simply reversing these measures,” the person said.
The repo rate – the rate at which the RBI lends to banks – was 5.15% in February 2020 before the pandemic. The RBI then cut the repo rate by 75 basis points in March 2020 and a further 40 basis points in May 2020, bringing the total rate cut over the year to 115 basis points. The CRR (Cash Reserve Ratio or the percentage of depositors’ money that banks are required to park with the RBI), which is another key monetary tool to manage liquidity, was cut by 100 basis points in March 2020 and was then increased by the same amount in June 2021.
Just a week ago, on May 4, after an unscheduled meeting of its monetary policy committee, the RBI raised the Repo rate by 40 basis points to 4.40% and the CRR by 50 basis points to 4. .50%. RBI Governor Shaktikanta Das said this was aimed at containing high inflation amid global turmoil following the Russian-Ukrainian war.
Bring below comfort level
With inflation having breached the RBI target range, the focus is now on controlling it within the comfort level. This is the main reason for last week’s rise in the repo rate and the cash reserve ratio.
This was the first Repo rate hike by the central bank since August 2018. Analysts pointed out that the move, in a way, reversed RBI action in May 2020 from a 40 bp Repo rate cut basic. They noted that a complete reversal of allowed hosting during the pandemic period would force the RBI to increase the Repo rate by another 75 basis points. To combat inflation – which has plagued developed countries including the US, the RBI and other countries’ central banks should take coordinated action to kill demand over the next 6-8 months. “A 50 basis point hike in CRR only removed Rs 87,000 crore. There is Rs 6.5 lakh crore flowing into the liquidity adjustment facility every day. No power on earth can take that away in a day. It should be a multi-year process. All possibilities are open,” the person said.
On April 8, the monetary policy committee had raised the inflation forecast for 2022-23 by 120 basis points to 5.7%. Retail price inflation in March hit a 17-month high of 6.95%, the third consecutive month that inflation remained above the upper limit of the RBI’s medium-term target range of 2 to 6%.
The RBI has also intervened in the forex market in recent days to check the volatility of the rupee, but the RBI does not defend any particular level but just tries to smooth out any “jerky movement”, the person said. The rupee fell to an all-time low of 77.44 against the dollar earlier this week.