Context

The RBI has decided to take the bull by the horns. It has raised the repo rate by 40 basis points and the cash reserve ratio (CRR) by 50 basis points to fight inflation.

Why major central banks across the world are hiking rates?

• Across the world, major central banks have of late gone on a rate hike spree, waking up to the realisation of inflationary pressures not being transitory in nature.
• Record high inflation in the US: The US Fed has been on the offensive battling a 40-year high surge in prices.
• It has tapered its bond purchase programme drastically while suggesting in no uncertain terms the pace of rate hikes needed to combat inflation.
• The European Union has been slow to respond but voices are growing to correct the path at the earliest.
• Banks like the Central Bank of Brazil or the Russian Central Bank have increased the interest rate to double digits.
• Emerging economies have been doubly hit — the days of easy liquidity are well behind them even as their economic resources remain constrained to support an uneven proportion of population hit by pandemic.
• Including the RBI’s decision today to push the benchmark rate to align with the current market realities, 21 countries have increased interest rates so far.

Analysing the RBI’s decision to hike interest rates

• To this extent, the decision by the RBI to frontload the rate hikes ahead of the Fed decision is again an attempt to stem capital outflows.
• Accommodative policy stance; The most interesting aspect of the rate hike today is the continuation of the accommodative policy stance.
• The CRR hike may be just an attempt to build up a war chest on the liquidity front.
• Liquidity inflows to the financial system could be either policy induced by the central bank for example changes in reserves, open market operations etc or non-policy induced such as foreign exchange reserves, government cash balances, and currency in circulation.
• Given that non-policy induced liquidity inflows have been recently impacted (outflows of portfolio capital) and given the huge size of the government borrowing programme, the RBI also needs to support the market through some means.
• Impounding bank reserves through the CRR (Rs 87,000 crore) could give some space to the central bank to conduct open market purchases of bonds from banks and thus inject concomitant liquidity some time in the future if the need so arises.
•  The CRR rate hike is thus an important tool to possibly manage G-sec yields.

Inflation dynamics in India

• The inflationary pressures can be attributed mainly to adverse cost-push factors, coming from supply-side shocks in food and fuel prices.
• The RBI statement thus cites food inflation as a major source of discomfort.
• Additionally, nominal rural wages for both agricultural and non-agricultural labourers picked up during the second half 2021-22.
• However, such wage growth has remained soft.
• Measures to ameliorate supply-side cost pressures would be thus critical at this juncture, especially in terms of a calibrated reduction of taxes on petrol and diesel.
• On the policy side, however, it would mean that even after rate hikes, inflation may continue to remain high for some time.
• The MCLR (Marginal Cost of Funds based Lending Rate) linked loans have a share of around 53 per cent in the overall loan kitty.
• With the rise in CRR and expected future hikes in the benchmark rates, there would be an increase in MCLR due to a negative carry.

Conclusion

The RBI has acted prudently in responding to market forces that could impact India’s growth prospects if inflationary concerns were not addressed now. At the same time, by pledging to remain accommodative to spur, and reinvigorate growth, it has reaffirmed its commitment to being a trusted partner in the growth of the country.

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