Interest rates expected to continue to rise

by Janaki Samant

The Reserve Bank of India (RBI) hiked policy repo rate by 50 basis points (bps) to 5.9 per cent, today. The standing deposit facility (SDF) now stands at 5.65 per cent and the marginal standing facility (MSF) is at 6.15 per cent. This is the fourth instance of a hike in repo rate by the RBI. In all, the RBI has hiked rates by 190 basis points since the beginning of the current fiscal year. Policy repo rate went up from 4 per cent at end-March to 5.9 per cent after today’s hike. It is now at a more than 3-year high. RBI has also decided to continue with withdrawal of accommodation.

The 50 bps hike in repo rate was widely anticipated. Of the 35 economists surveyed by Bloomberg, 24 had expected RBI to hike repo rate by 50 bps. The RBI was widely expected to take the repo rate to six per cent in its bid to contain rising inflation. But it is likely that rate hikes could continue. Rate hikes so far have not succeeded in reining in inflation.

Retail inflation, as measured by the Consumer Price Index (CPI), has remained at or above seven per cent in four out of the five months, in the current fiscal year. After easing to 6.7 per cent in July, retail inflation again rose to seven per cent in August. Retail inflation has been persistently above the upper limit of the RBI band of 4 to 6 per cent since January 2022.

The RBI has retained its inflation forecast at 6.7 per cent during 2022-23, in today’s monetary policy review. It expects inflation to ease below the upper limit of the RBI target band to 5.8 per cent in the last quarter of 2022-23.

But we believe that headwinds to inflation persist. These can be expected to prompt the RBI to go in for additional rate hikes in the coming months.

Price of Indian basket of crude oil has eased in the recent past. It was ruling at below USD 90 per barrel in the last week of September from over USD 105 per barrel in the last week of August. This is expected to take some of the pressure off from the rising trajectory of retail inflation. However, OPEC has announced a production cut, though relatively small, from October 1, to stabilise prices. Easing global metal prices are also likely to contribute in bringing down domestic inflation in metals.

But, on the flip side, the discontinuation of supply of natural gas by Russia to European countries had led to surging prices of natural gas. This contributes to driving up inflation.

Further, food inflation is likely to see an increase. Uneven spatial and temporal distribution of rainfall during the just-concluded southwest monsoon season, lower sown area under rice and pulses and high vegetable inflation are expected to contribute to high food inflation.

The increase in gas prices and the possibility of elevated food inflation would inflation high which in turn would keep the pressure on the RBI to raise rates further. International rates is the other factor that would keep the pressure on RBI.

The US Federal Reserve hiked benchmark short-term rate by 75 bps on September 21. The Fed chairman also signalled more rate hikes to contain inflation. At 8.7 per cent in August, inflation in the US is way above its target rate of 2-3 per cent. Currently, the US short term benchmark rate is at 3-3.25 per cent. The Fed forecast that it would hike benchmark rate to around 4.4 per cent by end-2022. This was 100 bps higher than the forecast made in June. The Fed expects to hike rate further to 4.6 per cent in 2023. However, analysts expect that the US benchmark rate would have to go up to around 5-5.25 per cent to bring down soaring inflation.

The European Central Bank hiked policy rate by 75 bps. It expects the hikes to continue in order to bring down inflation.

These hikes in interest rates in the developed world puts pressure on the RBI to raise rates correspondingly to avoid the possibility of an increase in capital out-flows.

The impact of the hike in US benchmark rate on FII flows in India was immediately evident. After the US Fed rate hike, there were net FII outflows of USD 1.9 billion.

This has exerted pressure on the rupee. The exchange rate slipped below Rs.80 per US dollar, to Rs.80.72, on September 2022. By September 29, it plunged further to Rs.81.86 per US dollar. On September 1, the exchange rate was at Rs.79.4 per US dollar. The rapid depreciation of the Indian rupee against the USD is expected to lead to imported inflation. It also has repercussions for trade deficit and current account balance.

Evidently, there are several factors that are expected to continue to fuel high inflation levels in the coming months. The RBI has stated in its review that if high inflation is allowed to linger, it invariably triggers second order effects and unsettles expectations. Given this view, RBI can be expected to act to contain inflation. It is unlikely that the RBI has reached the terminal repo rate. Further hikes in policy repo rate in the coming months are a distinct possibility.