Bi - Monthly - Monetary Policy - What’s in store for interest rates in the future

Financial Services Risk

RBI Governor – Bi-Monthly – Monetary Policy – What’s in store for the interest rates in the future – A look at RBI’s recent move and its implications

The first bi-monthly Monetary Policy Committee meeting for the financial year 2023-24 happened over a period of 3 days – April 3, 2023, April 5, 2023, and April 6, 2023. The market was expecting a rate hike and to some extent had priced in a rate hike as well. However, much to everyone’s surprise, the Reserve Bank of India (“RBI”) announced no rate hike. Before the announcement, I thought there would be no rate hike, but I was amongst the minority in the market. It is important to understand here that the RBI has paused the rate hike and has in no way communicated a scenario of continued accommodation. The impact of rate hikes is usually seen with a lag, and it is important to observe whether the past rate hikes have had their effect. A rate pause allows the RBI to see how the inflation trajectory is going down because of past rate hikes. Credit activity has also been slowing down. It is with this background, that the RBI decided on a rate pause.

Further, dramatic interest rate increases have caused significant financial stability risks globally, as is evident from some of the recent regional bank collapses in the US, the Credit Suisse take over by UBS and the fault lines seen in some of the leading European Banks. While the Indian Banking system is robust from a capital and liquidity standpoint, it was imperative for the RBI to take a pause and re-assess the inherent financial stability risk as a matter of prudence.

In my view, the above two reasons were some of the significant reasons for an absence of rate hike in this bi-monthly MPC meet. At the risk of sounding like a crystal ball gazing soothsayer, I personally do believe that the interest rate hikes have not yet ended and the RBI has its arsenal another 50 basis points of rate hikes. While I may sound like a soothsayer, below are three justifications for my thought process

1)      Global Interest Rate Increases – With the interest rates increasing globally, there will be continued pressure on the domestic currency, possibly resulting in imported inflation. While the RBI does have adequate foreign exchange reserves to intervene in the market, regular intervention is not prudent and against the free market principles. Hence, the RBI would need to use the interest rate as a tool to keep the exchange rate within a certain band.

2)      Infrastructure Outlays – With the government focus on large infrastructure spending, the demand for money within the ecosystem will be consistently high. Because of the same, the interest rates would need to be elevated to manage the increased demand for money. As a result, we expect the interest rates on the long end of the curve to be elevated.

3)      Slowbalization (a term that I borrow from the newspaper Economist) – Globalization is not a reality anymore. The world is moving towards regionalization, primarily because of the global geo-political tensions in the form of the Ukrainian conflict and Sino-American rivalry, that put the world in different camps. With this there will be market inefficiencies, because of sub-optimal supply chains which will result in elevated inflation globally.

Some of the implications that I additionally see from an India standpoint, are as below:

1)      Move towards greater capital account convertibility - Initiatives around GIFT City and liberalization in the Domestic Tariff Area, will ensure a continuous flow of foreign currency in the country helping us build reserves, which could help the RBI to keep exchange rate within a certain band. This will help avoid imported inflation.

2)      Increased focus on stressed testing – Given the recent Banking crisis being experienced globally, we expect the Indian Banking regulator to focus on stress testing with more stringent scenarios for the Indian Banking system.

3)      Continuous focus on liquidity – The RBI would continue to monitor the liquidity situation more closely, to ensure that systemic liquidity is always adequate, to avoid instances of fire sales of assets that tend to have contagion effects within the financial ecosystem.

While some may say that I paint a glum picture, I would only like to say that it is better to be prepared for the worst-case scenario as only then can you be geared towards achieving reasonably good outcomes. I believe the RBI operates with this principle and am sure that the country will be a beacon of growth in an otherwise somber world.