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Writing on the wall: Central bank begins to tighten and shifts priorities to fight inflation

With rising risks of monetary policy slippage, the Reserve Bank of India finally shifted its priorities from fighting inflation to boosting growth, with the possibility of a hike in its policy rate – the repo rate or the rate at which the RBI lends to banks – in the coming months.

While maintaining a dovish stance, the central bank has signaled a calibrated removal of dovish measures in this coming fiscal year. “Now is the time to prioritize inflation over growth,” RBI Governor Shaktikanta Das said after unveiling the bi-weekly policy review.

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

Significantly, the tone of the outcome of the Monetary Policy Committee meeting and the narrowing of the Liquidity Adjustment Facility (LAF) corridor should set markets up for a 50-70 basis point repo rate hike. from the current level of 4% – which has remained unchanged in the last ten policy reviews – in 2022-23.

The RBI has also introduced a new measure, the Standing Deposit Facility (SDF) – an additional tool to soak up liquidity – to suck up excess liquidity of Rs 8.5 lakh crore from the financial system which is fueling inflation. With this, the reverse repo rate has become almost irrelevant.

About a month ago, Jayanth Varma, a member of the RBI’s monetary policy committee, told The Indian Express that the MPC should do more to communicate its determination to defend the inflation target and its willingness to raise rates as needed. “My concern is that the accommodative position carries the risk of falling behind in the future as the position limits the freedom of action of the MPC in subsequent meetings,” he said.

Seeing the writing on the wall, the RBI raised its inflation forecast from the 4.5% projected earlier to 5.7% – still below the upper 6% range of the RBI’s target – in 2022-23 and reduced the growth rate from 7.8 percent to 7.2 percent.

The tightening of accommodative policy is normally accompanied by a rise in interest rates in the system. The US Federal Reserve had recently announced policy tightening and raised interest rates. While the RBI has focused on growth with its accommodative policy over the past three years, mainly to deal with the downturn triggered by the Covid pandemic, several analysts had recently said that the RBI was lagging behind in the fight against inflation and liquidity management.

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

“We face new but daunting challenges – shortages of key commodities; fractures in the international financial architecture; and fears of de-globalization. Extreme volatility characterizes the commodity and financial markets,” Das said. “Caught in the crosswind of multiple headwinds, our approach must be cautious but proactive to mitigate the negative impact on India’s growth, inflation and financial conditions.”

Das said the conflict in Europe now poses a crushing new challenge, complicating an already uncertain global outlook. “As the daunting headwinds of the geopolitical situation challenge us, the RBI is strengthened and ready to defend the Indian economy with all the instruments at its disposal. As we have demonstrated over the past two years, we are not hostage to any regulation and no action is on the table when the need of the hour is to protect the economy,” Das said. .

The RBI has signaled a shift in focus from boosting growth to mitigating inflation risks, Crisil said. “We expect (the repo rate hike) to be 50 to 70 basis points in fiscal 2023 from the June monetary policy review,” he said.

Upside risks to inflation show no signs of easing, with crude oil prices persisting above $100 a barrel and food and metals prices at record highs. “Along with increasing cost pressures, we expect consumer pricing pressure to also widen this fiscal year,” Crisil said.