RBI in its last two bi-monthly Monetary Policy Reviews on June 6 and August 1, 2018 successively hiked the short term lending rate to the banks twice by 25 basis points each. That is first, the Repo rate was hiked to 6.25% from 6% in June and again to 6.5%. That is an increase of 50 basis points in last two months. This has resulted into the interest rate touching two year high rate.
Moreover, RBI continued to maintain ‘Neutral Stance’ in its monetary policy outlook since June this year and declared its commitment to achieve the medium term target of inflation at 4% for the current fiscal. RBI’s first rate hike came in June Monetary Policy Review in more than four years period since 2014, during which it had either held up or reduced the key policy rate. It was widely expected that RBI may go for rate hike in June Monetary Policy Review. But many Economists were also in the belief that lending hike will only happen in August and RBI may hold the rate till that time.
In June review, the Reverse Repo rate was kept as it is at 6%. It is the rate at which RBI sucks liquidity from the economy- by borrowing from the banks. Bank rate was also put as it was at 6.5% then. From the last more than six months inflation has been a worrying factor for RBI, which was steadily rising. In April the retail inflation (Consumer Price Index or CPI) had rose to about 4.6%- which off late had constantly remained beyond RBI’s target level of around 4%. Overall, inflation has risen by 2.2 percentage points in last one year. Due to this, the August policy review saw adjustment in the Reverse Repo rate to 6.25% and Bank rate to 6.75%.
Oil price hike in the international market in recent times has put lots of pressure on India’s balance of Payments- particularly on the Current Account Deficit (CAD). Brent Futures in international market steadily rose from $50/Barrel on July 11, 2017 to $80/barrel by May 17, 2018. As India imports about 75 to 80 per cent of its crude from overseas, oil price hike imposes lots of burden on the Fiscal situation of the government and CAD condition of the economy. Already the CAD which was in a declining mode from 2013-14 to 2017-18 (down by 1 percentage point from 1.7% to 0.7%), has risen last fiscal steeply to 1.9% of GDP. This was before oil price hike in the international market. Now with higher oil prices pressure on CAD will be further high. RBI fears these factors will lead to higher fiscal strain and more inflationary situation in the economy. This was confirmed with recent RBI Households Survey reporting 20 basis points rise in inflationary expectations.
Further, rupee is also in a sliding mode at present, becoming weaker and weaker to dollar. It had already hit at one month lowest level at more than Rs.69 per dollar (July 23 and Aug 9, 2018). Though the Q4 GDP growth in the fiscal year 2017-18 has bounced back to 7.7%- highest in last 2 years- a clear sign of recovery of the economy back into the trend growth path. But fiscal pressure, oil price hike, inflationary tendencies and CAD burden all these factors may create trouble in the growth path.
Possibly this is the reason because of which RBI didn’t wait till August to control inflation, rather it immediately swung into action by raising the key lending rate in June itself. It hoped in the short run controlling inflation will boost demand in the economy- particularly the consumption demand.
Investment demand is already down from the private sector- due to ongoing banking sector crisis and higher NPAs. Private sector’s confidence is also not fully bounced back after the GST shocker, which might continue for some more time. To infuse investment into the economic system, it is majorly the public sector which is spending more. It has infused more capital into the banking system and announced slew of measures in the social welfare sector in this year’s Budget. Hence, in this scenario, maintaining the status quo in the Repo rate would have not helped the industries- which are in any way not spending more in investment and waiting for more time. And when the economy has started taking leaps into 7.7% zone, there seems to have enough leg room for tightening inflation by higher lending rate. In the short run this will not impact growth significantly. Another scenario of raising interest rate is that it will attract foreign capital towards Indian market leading to increased supply of foreign exchange and thus easing the pressure from the sliding Rupee.
So, when private investment is not doing well, promoting it via low interest rates in inflationary times and high fiscal and higher CAD burden would not have been advisable. Hence, better is to control inflation, stabilize the Rupee exchange rate and boost private consumption demand or at least maintain it at former level and not allowing it to fall. RBI has taken this line of thought.
Repo Rate and Reverse Repo rate work like two blades of a pair of scissors. When both increase, one makes lending to commercial banks by RBI costlier i.e. the Repo Rate. This in turn makes lending by the banks costlier to the Corporates and industries- thus lowering demand for liquidity leading to a check in growth of overall liquidity level in the economy. The Reverse Repo rate makes lending to RBI by the commercial banks attractive when RBI raises it- which is a safe parking of liquidity with the Central Bank. This also reduces liquidity in the economy when more money moves out of circulation and parked with RBI by the banks.
Thus both rate hikes act in tandem to control inflation in the economy by reducing overall supply of liquidity in the system. These are effective monetary policy tools now-a-days RBI is more frequently using vis-a-vis the other tools like Bank Rate and so on for inflation targeting in the short term. In June monetary policy review however, reverse repo rate was not hiked, but the greater inflationary concerns have forced RBI to use the double swords. Thus the August Review saw simultaneous hike of Repo and Reverse Repo rate.
The six-member Monetary Policy Committee kept note of the overall macro-economic scenario and evolving global economic developments while reviewing its Monetary Policy. It deliberated for 3 long days on issues like global oil prices, its likely impact on India’s Current Account Deficit (CAD) and also the Fiscal Slippage fears revolving around the Central Government. It is estimated that, every $10 per barrel rise in crude oil prices in the international market impacts India’s WPI inflation by raising it by 1.7 percentage points. Likewise, the CAD burden can rise by $9-10 billion from it as well as GDP can be reduced by about 0.2 to 0.3 percentage points. So, high oil prices at $70-75 is already a drag on the economy along with its growth risks, also maintained in an Oil Ministry statement. Moreover, rising bond yields in June has now softened.
Given all these scenarios, hardening of interest rate was inevitable in order to control inflation. RBI continues to maintain a medium term inflation target of around 4% within a band of +/- 2%. More so, the Monetary Policy Committee retains the policy of growth sustenance with the GDP forecast for 2018-19 at 7.4%. The best outcome of the deliberations by MPC was that, all most all members were unanimously in favour of rate hike. There is further expectation that this year RBI may go with further rate hikes- a total of 25 basis points, before finally stabilizing it at a comfortable level. This Monetary Policy Review is thus setting the tone of checks and balances on the government’s ‘Fiscal Populism’ intentions as 2019 General Election approaches- and RBI has started the ball rolling by unambiguously chasing the inflation first.
The Author: Shri Manoj Kumar Sahoo is a Faculty of Economics, School of Liberal Studies, Pandit Deendayal Petroleum University, E-mail: firstname.lastname@example.org