To the Reserve Bank of India’s (RBI) six-member Monetary Policy Committee (MPC), tasked with framing interest rate policy in a scenario of fast-moving, often contradictory macro signals, the ‘interesting’ times we are living through must, doubtless, seem more like a curse than a blessing. A particularly ominous one at that.
Just when the havoc wrought by the covid pandemic seemed to have subsided and central banks were hoping to return to normality, war in Ukraine and the resultant spike in commodity prices and renewed supply chain disruptions have up-ended all hope of getting back to business-as-usual.
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Consider the backdrop against which the MPC met over the past two days, preparatory to delivering its verdict on policy interest rates this Friday. Earlier this month, the US Federal Reserve, the Big Daddy of all central banks, hiked the federal funds rate (the indicative rate at which banks lend each other overnight) by 75 basis points to 3-3.25%, the highest in nearly 14 years. The Fed’s famed dot plot now shows interest rates are likely to reach 4.4% by December 2022, above the 3.4% projected in June, before rising to 4.6% next year, even as GDP growth forecasts have been revised lower to show a 0.2% expansion this year, compared to 1.7% seen in June and 1.2% in 2023, below 1.7% seen in June.
The message is clear. The Fed intends to walk the talk and hike interest rates, never mind if it inflicts economic pain. The Fed is not alone. Other central banks, including the Bank of England and the European Central Bank have been swift to follow, with the Swedish central bank hiking rates an unprecedented 100 basis points.
Meanwhile, the war in Ukraine shows no sign of ending. And while commodity prices have come down from the peaks witnessed earlier in the year, they continue to be volatile. Worse, there is no certainty the current softening in oil prices will continue. High commodity prices, especially high oil prices, are unambiguously bad news for us since almost 80% of our oil requirements are met by imports.
The resultant worsening of our current account deficit (latest numbers suggest we will end the year with this deficit above the danger mark of 3%), combined with an already high fiscal deficit (the combined deficit of the Centre and states is estimated at close to 11%) raises the spectre of a return of the bad old days of twin deficits: current account and fiscal.
Add to that a depreciating domestic currency in response to a strengthening US dollar and flight of dollars in search of a safe (read US) haven, and its implications for already heightened inflationary pressure, and we have the recipe for a perfect storm.
Sure, there is some comfort on the growth front. High frequency data suggests we will end fiscal year 2022-23 with growth in the region of 7-7.2% (not very far from RBI’s estimate of 7.2%), even as much of the world heads into a recession (two consecutive quarters decline in GDP). But it is naïve to assume India can remain an outlier in a slowing world economy. It is only a matter of time before out nascent recovery is nipped in the bud and growth peters out.
Looming over these dark clouds is a Damocles sword—RBI’s need to write a letter to the government, a mea culpa as it were, explaining why the MPC failed to meet its inflation target for three consecutive quarters and the remedial steps proposed to get inflation under control.
In such a scenario, what can the MPC do? For starters, it will need to decide whether its new- found priorities—inflation first and growth second —still stand. Or whether, in view of the likelihood of a growth slowdown and higher interest rates impacting government borrowing costs, and hence its ability to finance capital expenditure, it needs to re-balance its priorities. Just a little.
Could hiking interest rates by 50 basis points for the third time running, both to tackle inflation and to be in sync with global central banks, while changing the stance from “withdrawal of liquidity" to “neutral" be just what the doctor ordered? Remember, liquidity has been tightening in response to higher credit offtake and increasing foreign exchange (forex) intervention by RBI to support the rupee and thereby prevent sharp depreciation. (Each time RBI sells dollars in the market, it withdraws rupees.)
This balancing act is not going to be easy. India’s central bank, like other central banks, will have to learn to be “nimble", as Jerome Powell, the Fed chair, famously pointed out recently. The problem is that monetary policy, by its very nature, is a broad-brush instrument, characterized by long and uncertain lags. Soft landings and pirouettes are alien to flat-footed central banks, better known for their proclivity to over-shoot first in one direction and then in the other, rather than for being able to deal with ‘interesting’ times. Here’s hoping our MPC gets it right today!
Mythili Bhusnurmath is a senior journalist and former central banker.
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