To raise rates or not? RBI focuses on growth but Russia-Ukraine war could upset its math

Earlier this month, the Reserve Bank of India (RBI) surprisingly kept its benchmark repo and reverse repo rates unchanged for the tenth consecutive time even though some market observers had been expecting an increase.

In its bi-monthly monetary policy review, the RBI retained the repo rate at 4% and the reverse repo rate at 3.35% as it continued to focus on economic recovery instead of shifting its attention towards controlling inflation.

While the RBI has been debating how soon it should begin tightening its monetary policy, it forecast that the Indian economy could see a real growth rate of 7.8% in 2022-23 and that inflation could ease in the coming financial year, according to the minutes of the central bank’s Monetary Policy Committee meeting. 

However, Russia’s military attack on Ukraine on Thursday could upset the RBI’s calculations. Here’s what the minutes indicate about the RBI’s potential action and how geopolitical developments could cloud the outlook.

RBI’s growth forecast and the lone dissenting view

The central bank said it will continue with an accommodative stance as long as necessary to revive and sustain growth on a durable basis and continue to mitigate the impact of COVID-19 on the economy.

It said that recovery in domestic economic activity is yet to be broad-based, as private consumption and contact-intensive services remain below pre-pandemic levels.

The impact of the ongoing third wave of the pandemic on the recovery is likely to be limited relative to the earlier waves, improving the outlook for contact-intensive services and urban demand.

The announcements in the Union Budget 2022-23 on boosting public infrastructure through enhanced capital expenditure are expected to augment growth and crowd in private investment through large multiplier effects.

The pick-up in non-food bank credit, supportive monetary and liquidity conditions, sustained buoyancy in merchandise exports, improving capacity utilisation and stable business outlook augur well for aggregate demand.

Taking all these factors into consideration, the RBI projected real GDP growth for 2022-23 at 7.8% with Q1 growth at 17.2%, Q2 at 7%, Q3 at 4.3%, and Q4 at 4.5%.

However, one MPC member took a position different than the rest of the members. Prof. Jayanth R. Varma said he was voting in favour of maintaining the policy rate at 4% but voting against the policy stance for two reasons.

First, a switch to neutral stance is now long overdue, he said. Second, he said, “the continued harping” on combating the ill effect of the pandemic has become counterproductive and deflects the focus of the MPC away from the core issue of addressing the recessionary trends that go back at least to 2019.

RBI’s inflation assessment

The central bank retained the inflation projection for 2021-22 at 5.3%, with Q4 (January-March 2022) at 5.7%.

It expects CPI inflation for 2022-23 to ease to 4.5% on the assumption of a normal monsoon in 2022, with Q1 at 4.9%, Q2 at 5%; Q3 at 4%, and Q4 at 4.2%.

The MPC said inflation is likely to moderate in the first half of next fiscal year and move closer to the target rate, providing room to remain accommodative. Timely supply-side measures from the government have helped contain inflationary pressures, it said.

The central bank said that, since its December 2021 meeting, CPI inflation has moved along the expected trajectory. Going forward, vegetables prices are expected to ease further on fresh winter crop arrivals. Prospects of a good Rabi harvest add to the optimism on the food price front.

Russia-Ukraine impact, oil and rupee

The RBI said that global financial market volatility, elevated international commodity prices, especially crude oil, and continuing global supply-side disruptions pose downside risks to the outlook.

The global macroeconomic environment is characterised by deceleration in global demand in 2022, with increasing headwinds from financial market volatility induced by monetary policy normalisation in the systemic advanced economies and inflationary pressures from persisting supply chain disruptions.

The MPC acknowledged that the outlook for crude oil prices was uncertain due to geopolitical developments even though supply conditions were expected to turn more favourable during 2022.

Indeed, crude oil prices have already crossed $100 a barrel for the first time since 2014 after Russia attacked Ukraine. This could hurt India, which imports nearly 80% of its requirements.

To be sure, Indian oil companies haven’t raised retail prices of petrol and diesel for the past couple of minutes due to elections in five states. However, prices are likely to be increased after March 7 when the elections end.

Prices of sunflower oil could also go up since Russia and Ukraine account for 90% of India’s sunflower oil imports. In fact, sunflower oil is India’s second most imported edible oil, next to only palm oil.

In 2021, India imported 1.89 million tonnes of sunflower oil. As much as 70% of this was from Ukraine alone. Russia accounted for 20% and the balance 10% was from Argentina.

Higher prices of crude and cooking oil would raise India’s import bill, widen the trade deficit and jack up inflation.

This is not all. The war will also turn global investors more risk-averse, prompting them to continue pulling out money from emerging markets and shifting to safer, developed markets. On Thursday, India’s stock market plunged 4.6% while the rupee tumbled more than 1.5% to fall past 75 to a dollar. A weaker rupee makes imports costlier.