RBI’s pause could increase risk of importing inflation

Considering the lag in monetary policy transmission, the impact of rate hikes (if any) in the next two MPC meetings is unlikely to be felt before the next year.

The Reserve Bank of India (RBI) had a difficult choice to make, and it stuck to the approach of the last few instances — a pause but with some hawkish commentary.

The dilemma of the RBI was understandable. It is not just the RBI; the broader markets have been in a dilemma. Policy experts have long warned of the impact of rising rates on expanded balance sheets. However, despite the ever-increasing debt and interest rate levels in the United States, the markets have been rallying.

Global central banks have been raising rates to cool down inflation on the back of strong economies. However, the inflated balance sheets, coupled with increased rates, have led to significant increase in the interest expense outflow. The sustainability of this growing interest expense, particularly for the US has been called into question since the US Fed started tightening. The US Fed’s own expectations is for rates to rise to 5.6 per cent this year before gradually beginning to ease.

The jury is still out on whether the market rally is due to the inherit strength of the economy (as claimed by the central banks) or is the market’s attempt to price in the impending rate cuts. However, what is clear is that the music cannot last for very long.

How long can the music last?

Bill Ackman, a noted US hedge fund manager, recently disclosed a short position on the US treasuries. Warren Buffet, known to be one of the greatest investors of our times, continues to be long the short-term US treasuries. The current market sentiment points to a 90 per cent probability of the US Fed raising rates in its September 23 meeting.

Clearly, the US interest rates are likely to trend up across the short and long end of the curve for the next few months. Does that lead to a cut in the US rates? Probably, by the end of 2023.

How long can RBI hold fort?

The RBI has not raised rates since February 23. as per a Reuter’s poll, inflation in July 23 may have breached the RBI’s comfort zone of 2-6 per cent.

Although much of the increase could be attributed to the sudden surge in food prices, in view of another impending US rate hike, the RBI’s pause is likely to further import inflation. In fact, the RBI expects inflation to be above its tolerance level of 6 per cent for Q2 FY24, which should then cool off to 5.7 per cent in Q3 FY24.

The end of Q2 witnesses tighter liquidity conditions. However, this year might be a bit difference with improved liquidity conditions from the deposits of the Rs 2000 currency note. Add to it the festive cheer that should last throughout September, the current inflationary conditions could well spill over into Q3 FY24.

The production cut from OPEC and Russia has already led to an increase in the crude prices, which along with a stronger currency could lead to a further spike in inflation.

A surprising disconnect

The RBI Monetary Policy Committee (MPC) document recognises the risks stemming from uncertain macroeconomic factors and rising crude oil prices. However, the decision to pause appears to be the result of an unusually positive perspective based on strong domestic consumption, robust private sector financial positions, and increased government expenditure.

In view of a near certain US Fed rate hike in September 23, policy inaction is likely to increase the risk of importing inflation. After the August 10 rate decision, the RBI’s MPC will meet twice this year (in October and December). Considering the lag in monetary policy transmission, the impact of rate hikes (if any) in the next two meetings is unlikely to be felt before the next year.

Whether it is the government’s initiatives to limit imports of laptops or exports of rice or the RBI’s response to the changing macroeconomic environment, the India story needs a coherent policy resolve to sustain momentum and growth.

Anuj Dhawan is Head of Corporate Strategy, Equipped AI.

The views expressed above are the author's own. They do not necessarily reflect the views of DH.