RBI Surprise Rate Hike: What, Why, Why Not, And Where

For some time now, the markets have felt the Reserve Bank of India is behind the inflation curve.

This author had written back in September 2021 that it was time to begin the long process of exiting from a two-year period of ultra accommodative policies. That, in a traditional sense, would have entailed a sequenced and step-by-step move to first raise the lower end of the interest rate corridor (at that time the repo rate), change monetary policy stance to neutral (to reflect that the next rate move would be higher), start withdrawing surplus liquidity and eventually raise the repo rate.

The RBI didn’t act in October, it didn’t act in December, it didn’t act in February. Then, perhaps realising that it had waited too long, the central bank has done a rather quick course-correction in April and now in May.

The ‘What’

Let’s first start with the what.

The RBI and the Monetary Policy Committee acted together in the surprise move.

The MPC raised the benchmark repo rate by 40 basis points for the first time in four years. The last rate hike was in August 2018 during the tenure of former governor Urjit Patel. Between February 2019 and May 2020, India reduced rates by 250 basis points. Of this, 115 basis points was after the Covid-19 crisis hit.

With the May 4 rate hike, RBI has undone about a third of the accommodation provided in response to Covid, at least by way of lower repo rates.

But the unscheduled action must be seen together with the scheduled April move. Until then, the reverse repo rate of 3.35% was being seen as the effective rate. Now the RBI has moved to the standing deposit facility and the rate at this window is pegged at 25 basis points below the repo rate. As such, the SDF rate is now at 4.15%.

Since liquidity remains surplus, the SDF rate will still be the guiding rate. This rate, which is the floor for interest rates, has now been raised from 3.35% to 4.15% – that's about an 80 basis point hike in the effective rates.

Alongside, the RBI is slowly trying to withdraw liquidity.

In a recent research document called Report on Currency and Finance, the central bank had said that liquidity of more than 1.5% of net demand or time liabilities, broadly bank deposits, is inflationary. At present the liquidity surplus is a little more than 4% of NDTL.

To start with, the RBI has pulled out about Rs 87,000 crore or about 0.5% of NDTL. Even after this there is a lot of liquidity in the system and the RBI may choose to hike the CRR further at subsequent meetings.

The 'Why'

The ‘why’ of the situation is a combination of factors.

One, the hope that inflation is ‘transitory’ has proved to be, well, ‘transitory’. Supply-side or not, inflation pressures are coming from everywhere. Food prices and fuel prices, in particular, are pushing inflation prints into ugly territory.

There will be arguments that rates can do little to bring down food or fuel prices. Yet, higher rates, as the RBI has argued in document after document over the years, can help reduce the second-round impact of these higher prices by keeping inflation expectations in check.

Inflation in India has already hit 7% in March and will likely head higher in April. An inkling of how bad April inflation is likely to be would have prompted the emergency meet in large part.

The U.S. Federal Reserve’s expected tightening and the fear that India will be seen as behind the curve would have played an equally large part.

The RBI has so far managed to keep the rupee stable by selling from its reserves but it would be mindful that outflows could accelerate if interest rate differentials widen and if investors start viewing emerging markets that are soft on inflation negatively.

The 'Why Not'

So we know what RBI did and we have a reasonable sense of why it did so. But there is one perplexing ‘why not’ that remains.

While raising rates, the MPC said its stance remains ‘accommodative while focusing on withdrawal of accommodation’. Why haven't the MPC members moved the stance to ‘neutral’?

In yesteryears, the stance signaled the likelihood of the next move on rates. Accommodative meant that rates would only move down; neutral meant rates would stay unchanged or move higher; a tightening stance would mean that rates would only move higher.

So a rate hike with an accommodative stance, as columnist Niranjan Rajadhyaksha pointed out in a Twitter exchange, is unusual.

The only way to explain this is to speculate that the RBI and the MPC now see the stance as a reflection of the nature of monetary policy relative to the economy. In the current situation, despite the rate hike, real rates are negative and liquidity in ample surplus. As such, the policy environment remains ‘accommodative while focusing on withdrawal of accommodation’ seems to be message communicated with the stance.

The 'Where'

The final question to ask after the emergency decision is where from here. Where do policy rates settle in the current cycle.

The answer to this is wide-ranging.

The markets, as seen in the overnight index swaps segment, is pricing in rates as high as 7%. But there is likely some, if not considerable, overshooting there.

The reality is that the tightening to fight inflation is coming against a weak economy. Unless inflation continues to surprise to the upside, the RBI will need to keep an eye on growth as well.

And so, the majority view among economists, is that rates may settle closer to 5.5% by the middle of 2023.

This 40 basis point rate hike, then, is just the beginning.

Ira Dugal is Executive Editor at BloombergQuint.