Continuing its fight against rising inflation, the Reserve bank of India (RBI) has increased the repo rate by 50 basis points (bps) to 4.90%.

More rate hikes are on the table as inflation has emerged as a major threat to the growth process. While the RBI expects growth to proceed on a stable path, inflation needs to be addressed. Experts across the spectrum expect the repo rate to go beyond the pre-Covid level to close at around 6% by the fiscal-end.

“We foresee further repo hikes of 35 bps and 25 bps, respectively, in the next two policies. However, the upmarch in the yields will now be somewhat shallower than our earlier expectations," says ICRA chief economist Aditi Nayar.

Yes Bank chief economist Indranil Pan believes that the front-loading strategy will continue and he pencils in another 40 to 50 bps increase in the repo rate in the RBI’s August monetary policy.

“Thereafter the RBI may have to be more lenient in the extent of increases, keeping in line with its current inflation trajectory which also points to a sub-6% number in the fourth quarter. By December, the RBI should have raised the policy rate to 5.80-6% and pause thereafter to assess the implications of the cumulative 180-200 bps increase on both growth and inflation," he says.

RBL Bank chief economist Rajni Thakur expects a similar rate hike of 50 bps in August, which will take the repo rates higher than pre-Covid levels. “This will be followed by pause to re-access the macro-dynamics and hikes in smaller quantum thereafter pushing year-end repo rates close to 6% levels,” she says.

Thakur, however, admits that it is difficult to gauge a terminal rate level for the cycle due to geo-political uncertainties and multiple risks on price levels driven largely by external factors. 

Just last month, the RBI had hiked the repo rate by 40 bps to 4.40% and the cash reserve ratio (CRR) by 50 bps to 4.50%. The off-cycle hike ahead of the bi-monthly monetary policy in June was taken in the backdrop of soaring inflation.

The rate hike cycle has come after a prolonged period of low interest rate. After the onslaught of the coronavirus pandemic, the RBI had slashed the repo rate in March 2020 and maintained status quo in the benchmark interest rate for almost two years before increasing it on 4 May 2022.

Inflation forecast revised to 6.7%

The RBI has increased its FY23 inflation forecast to 6.7% from 5.7% earlier while keeping the GDP growth projection unchanged at 7.2%. 

With inflation expected to be 6.7% this fiscal, it will take a long time to move to a positive real interest rate regime. Home, auto and personal loans are to quickly rise. Interest rate on deposits will also rise but not be in line with the policy hikes yet as there is still liquidity in the system.

"The higher interest rates will get transmitted directly for loans which are linked to external benchmarks such as home loans or SME (small and mid-sized enterprises) loans. However, MCLRs (marginal cost of funds-based lending rate) will be slower to react in terms of quantum of change," says Madan Sabnavis, chief economist at Bank of Baroda.

"The same will hold for deposit holders who will receive higher rates depending on how banks adjust their rates based on their funding requirements. As there is surplus liquidity currently in the system which can go for lending, the immediate response may be slow," Sabnavis adds.

Abheek Barua, chief economist at HDFC Bank, believes today's monetary policy moves beyond just front-loading of interest rate increases. "The central bank seemed far more concerned about inflation - reflected in its upward revision in its inflation forecast by 100 bps to 6.7% - and relatively more sanguine on domestic growth impulses. Clearly, the RBI is concerned about the broad-based nature of the increase inflation and the risk of the second-round impact on inflation expectations. Therefore, the policy rate is likely to be raised well beyond the pre-pandemic level, close to 6% by fiscal year-end," he says.

A quarter-wise break-up of the revised inflation projection in FY23 is as follows: Q1 - headline CPI is expected to be 120bps higher at 7.5% from 6.3% earlier; Q2 - expected to be 160bps higher at 7.4%; Q3 - +80bps higher at 6.2%; and Q4 - +70 bps higher at 5.8%

The policy flagged significant upside risks to inflation. These included supply shocks emanating from adverse global factors; heightened risks to food inflation from ‘shortfall in the rabi production due to the heat wave’; edible oil prices remaining under pressure; and second round pass through to pump prices on account of increase in international crude prices. 

“Notably, in the current policy document average crude price assumption has been kept at US$ 105/bbl, which is also subject to considerable risks, considering the current run rate at ~US$ 120/bbl,” Dipanwita Majumdar and Sonal Badhan, analysts at Bank of Baroda, said.

How are bond yields going to behave? "Bond yields saw an initial relief rally post the policy announcement as the rate hike was broadly priced-in and the fear of a larger rate increase or a CRR hike has been alleviated. That said, with elevated oil prices and rising global yields, this rally is likely to be short-lived and yields could march north yet again," Barua avers.

RBI has maintained its growth forecast for FY23 at 7.2% as it believes that recovery is gathering strength. High frequency indicators such as railway freight volumes, port cargo, air passenger traffic and GST collection have shown pick up in 2022 in the period between April-May. In addition, RBI believes that a normal monsoon will support rural consumption. 

Also, improvement in capacity utilisation (74.5% in Q4FY22) and government’s commitment in the FY23 budget to boost capex spending is expected to aid investment growth this year. This, in turn, will trigger bank credit growth. Global demand is also expected to help India’s exports in goods and services. “However, prolonged war between Russia and Ukraine, supply chain bottlenecks and high pressure on input costs may impact margins of companies, thereby contributing to downward risks to growth,” Majumdar and Badhan  write.

Liquidity measures

Standing deposit facility (SDF) rate, which was introduced in the April 2022 policy as the floor of LAF (liquidity adjustment facility) corridor, was set at 3.75% (+40bps). Following the May policy decision, this was hiked to 4.15%. With the recent policy, this stands at 4.65%, implying a cumulative increase of 130 bps since the start of FY23. This has built upward pressure on all tenures of interest rates and reduced systemic liquidity in the system, indicating that RBI is on track for “gradual withdrawal of accommodation”. 

RBI, however, has noted that there still remains an overhang of excess liquidity in the system, which is keeping average overnight rates below the repo rate. On the longer-end, borrowing rates have increased and so have banks’ term deposit rates, which will help banks in gathering resources to fund credit growth.

Other key highlights of the monetary policy are:

. Credit cards, starting with RuPay credit cards, can now be linked to the UPI (Unified Payments Interface) platforms. This facility would be available after the required system development is complete.

. Limit for e-mandates/ standing instructions on cards and prepaid payment instruments (PPIs) for recurring transactions increased to Rs 15,000, from Rs 5,000 at present.

. Limit of individual loans extended by co-operative banks hiked by 100%

. Marginal Standing Facility (MSF) rate & Bank rate raised to 5.15% from 4.65%

. RBI decides unanimously to keep policy stance ‘withdrawal of accommodation’