Writing on wall: Central bank begins tightening, shifts priorities to tackle inflation

With rising risks of the monetary policy falling behind the curve, the Reserve Bank of India has finally shifted its priorities to tackle inflation from reviving growth, with the possibility of a hike in its key policy rate — the repo rate or the rate at which the RBI lends to banks — in the coming months.

While maintaining an accommodative stance, the central bank has signalled a calibrated removal of accommodation in this financial year going forward. “Time is appropriate to prioritise inflation ahead of growth,” RBI Governor Shaktikanta Das said after unveiling the bi-monthly policy review.

“The RBI will engage in a gradual and calibrated withdrawal of this liquidity over a multi-year time frame in a non-disruptive manner beginning this year,” he said.

Significantly, the tone in the outcome of the Monetary Policy Committee meeting and narrowing of the liquidity adjustment facility (LAF) corridor is expected to prepare the markets for a repo rate hike of 50-70 basis points from the current level of four per cent – which remained unchanged in the last ten policy reviews – in 2022-23.

The RBI also introduced a new measure, the Standing Deposit Facility (SDF) — an additional tool for absorbing liquidity — to suck out surplus liquidity of Rs 8.5 lakh crore from the financial system which is fuelling inflation. With this, the reverse repo rate has almost become irrelevant.

Just about a month back, Jayanth Varma, member of the RBI’s monetary policy committee, had told The Indian Express that the MPC should do more to communicate its resolve to defend the inflation target, and its willingness to raise rates as and when required. “My concern is that the accommodative stance carries with it the risk of falling behind the curve in future because the stance limits the MPC’s freedom of action in ensuing meetings,” he had said.

Seeing the writing on the wall, the RBI hiked its inflation forecast from 4.5 per cent projected earlier to 5.7 per cent – still below the upper band of 6 per cent of the RBI’s target – in 2022-23 and slashed the growth rate from 7.8 per cent to 7.2 per cent.

The tightening of the accommodative policy is normally accompanied by a rise in interest rates in the system. The US Federal Reserve had recently announced a tightening of the policy and raised interest rates. While the RBI has been focussing on growth with its accommodative policy in the last three years, mainly to tackle the slowdown triggered by the Covid pandemic, several analysts had recently said the RBI is behind the curve in tackling inflation and liquidity management.

On Friday, the RBI policy panel took a concrete step by restoring the policy rate corridor under liquidity adjustment facility to pre-pandemic width of 50 basis points by introducing the SDF at 3.75 as the floor of this corridor. This is aimed at bringing down the inflationary pressures.
Liquidity adjustment facility (LAF) is a tool used in the monetary policy that allows banks to borrow money from the RBI through repurchase agreements (Repo) or to lend funds to the RBI through reverse repo agreement.

“We are confronted with new but humungous challenges – shortages in key commodities; fractures in the international financial architecture; and fears of deglobalisation. Extreme volatility characterises commodity and financial markets,” Das said. “Caught in the cross-current of multiple headwinds, our approach needs to be cautious but proactive in mitigating the adverse impact on India’s growth, inflation and financial conditions.”

Das said the conflict in Europe now poses a new and overwhelming challenge, complicating an already uncertain global outlook. “As the daunting headwinds of the geopolitical situation challenge us, the RBI is braced up and prepared to defend the Indian economy with all instruments at its command. As we have demonstrated over the last two years, we are not hostage to any rulebook and no action is off the table when the need of the hour is to safeguard the economy,” Das said.

The RBI has signalled shifting focus from reviving growth to mitigating inflation risks, rating form Crisil said. “We expect (the repo rate hike) to be 50-70 basis points in fiscal 2023 beginning with the June monetary policy review,” it said.

Upside risks to inflation show no signs of abating, with crude oil prices persisting above $100 per barrel, and food and metal prices at record highs. “Along with increasing cost pressures, we expect the pressure on consumer prices to broaden as well this fiscal,” Crisil said.

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