Not the Right Time to Tighten Interest Rates

Banking concerns in India
Unlike its
global peers rushing in to end the easy monetary policy, the Reserve Bank of India (RBI) may not be inclined to raise interest rates to stem inflationary pressures just when the nascent economic recovery is under threat from the Omicron variant of Coronavirus.

Both the government (whose aim is to boost growth) and the RBI (whose primary job is to rein in inflation) should give primacy to growth for some more time or till the end of 2022.

Traditionally, higher economic growth leads to inflation and an upward bias on interest rates. The Indian economy will grow by 9.2 per cent in 2021-22, according to the first advance estimate by the National Statistical Office (NSO). The de facto growth will be around 1.3 per cent over FY20 as the economy had contracted 7.3 per cent in 2020-21 due to the pandemic. The RBI has pegged the growth at 7.8 per cent for 2022-23.

The economy needs to sustain around 8 per cent economic growth annually to generate resources for welfare, social and infrastructure development projects to generate jobs and improve living conditions. This has become even more relevant after Covid-19-induced shock to the working class and the poor.

Despite upward pressure on inflation due to pandemic-induced supply constraints, the RBI should not hurry to normalize its monetary policy settings even as its peers in developed countries such as the US Federal Reserve and the Bank of England rush to taper easy monetary policy to battle inflation.

Instead of raising policy interest rates, which could make capital costly for investors, the RBI should suck out excess liquidity to the extent possible to keep inflationary pressures under check.

“Under current macroeconomic conditions, still weak demand conditions are flattening the Phillips curve (a theory that says with economic growth comes inflation and more jobs) in India, providing some maneuvering room for monetary policy to support the recovery without being hemmed in by demand-driven inflation concerns,” explains a recent RBI research paper authored by deputy governor Michael D. Patra, who is also a member of the monetary policy committee that decides on interest rates.

The RBI sees inflation peaking in the current January-March quarter at about 5.7 per cent before retreating to 5 per cent in the next two quarters, within its 2 per cent to 6 per cent inflation target band, giving it the desired elbow room to support growth. The union government and state governments will also have to ensure that supplies of goods are not choked due to restrictions imposed to curb the spread of Omicron.

While some commentators have been speculating about the likely interest rate hike by the RBI, the central bank is yet to talk about that possibility.

Should India not be worried about the US Federal Reserve System (Fed) tapering to curb the US’s 40-year high inflation? India should, going by its experience in 2013. 

In 2013, the Fed’s taper tantrum triggered capital outflow from India due to large scale liquidation of equity and debt exposures by foreign investors. This led to sharp rupee depreciation and a steep fall in equity prices.

However, India should not be overly worried this time as the fundamentals of the Indian economy are now stronger than in 2013. A huge buffer of over USD 633 billion in foreign exchange reserves now, compared with USD 270 billion in 2013, gives the RBI the space to insulate the economy from the volatility that comes with the Fed tightening cycle.

India’s other macroeconomic indicators also exhibit greater stability such as the current account deficit or CAD (difference between current receipts from abroad and current payments to abroad). India’s current account was in surplus at 0.9 per cent of GDP in the first quarter of 2021-22 and a deficit of 1.3 per centin the second quarter. In 2013, India’s faced its worst CAD of 6.8 per cent in the third quarter of that year.

This time, the RBI with high forex reserves is in a credible position to intervene aggressively in the foreign exchange market to smoothen out fluctuations in the value of the rupee due to foreign capital outflow. 

That said, the RBI has to address the huge liquidity overhang in the financial system. The RBI has been comfortable maintaining large surplus liquidity in the banking system as credit growth and money multiplier remains significantly below trend, thereby negating risks of liquidity fueled inflation. According to Deutsche Bank, this may change in the first half of 2022, as the output gap closes and credit growth/money multiplier starts rising from current levels.

As monetary policy transmission works with a significant lag, the RBI has started normalization of liquidity through variable-rate reverse repo (VRRR) auctions to prevent future inflationary pressure. Some analysts read the move to absorb more liquidity through VRRR auction could be the precursor to a hike in the reverse repo rate to suck out excess liquidity.

To sum it up, when the economy is on the rebound, knee-jerk reactions are likely to stifle it. The government must ensure the functioning of businesses are not unduly impacted due to the pandemic-related restrictions and supplies of essentials are smoothened to minimize inflationary pressures.

A gradual withdrawal of liquidity by the central bank would push the need to tighten policy interest rate towards the end of 2022, giving the desired oxygen to the economy.

Besides investors, a hike in interest rates by the central bank at this juncture will further inflate the interest cost of the Union government and the state governments, both of which are likely to have massive borrowing programmes in 2022-23 as well. So, a hike in the interest rate means, lower spending on developmental work, going forward.

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