Global economy is in trouble; RBI  optimistic

Sometimes monetary policy turns out to be a mere formality, like last Friday. The Reserve Bank of India (RBI) increased the repo rate, or the rate at which it lends to banks, by 50 basis points to 5.9%. One basis point equals 0.01%.

This increase was widely expected as the US Federal Reserve hiked its main short-term interest rate, the federal funds rate, by 75 basis points to 3-3.25% in September. Given that the US Federal Reserve sets the direction of global monetary policy, it makes no sense for another central bank to fight the Fed. RBI is no exception.

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In addition, interest rates in the Indian economy have risen anyway.

The RBI has attempted to defend the value of the rupee by selling dollars from its reserves and buying rupees. Until recently, there was a lot of money floating around in the financial system that the banks had no use for. So when the RBI sold dollars, they withdrew that excess liquidity. This and increased bank lending (as we shall see) have ensured that excess liquidity has now more or less come to an end.

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In addition, bank lending has picked up speed. On September 9, annual non-food credit growth was 16.7%, the fastest increase since September 2013.

By comparison, deposit growth on September 9 was 9.5% yoy, suggesting a sizeable gap between loan growth and deposit growth. This gap and the end of excess liquidity in the financial system have pushed interest rates higher. The demand for money has increased. The offer doesn’t.

The hope is that this rise in interest rates will help contain inflation, at least the consumer demand-driven part of it. RBI’s FY23 retail inflation forecast remains unchanged at 6.7%. According to the agreement between the RBI and the government, the upper tolerance limit for inflation is 6%.

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The RBI is deemed to have missed the inflation target if retail inflation stays above 6% for three consecutive quarters. As stated in the latest monetary policy statement, “In the first three quarters of 2022-23, inflation is likely to be above the upper tolerance level of 6%.” This means that the RBI is unlikely to fulfill its mandate this year.

What makes the situation worse is that core inflation (after the food and fuel cuts) remains elevated. In August it was just over 6%. As stated in the monetary policy statement, “Core inflation has remained at elevated levels, with upward pressure on various goods and services.” This means that inflation is not only being driven by high food and fuel prices, and it has been systemically will.

In view of the protracted war in Ukraine, the situation is unlikely to ease. In addition, the Fed and other rich-world central banks are attempting to fight decades of high inflation by raising interest rates, which is likely to result in an economic recession or a huge slowdown in the rich world.

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As Jerome Powell, Fed Chairman, said recently, “I think there’s a very good chance that we’re going to have a period… [of] significantly lower growth.” More and more economists are also forecasting a recession for Europe.

This will definitely have an impact on economic growth in India as well, by dragging down export growth on the one hand. Taking these factors into account, RBI lowered the FY23 economic growth forecast to 7%. Growth of 7.2% had previously been forecast. Globally, the RBI could turn out to be more optimistic than it should be. The optimism was evident in Governor Shaktikanta Das’s address, which ended with the statement: “Despite the clouds gathering over the global economy, the Indian economy is inspiring optimism and confidence today.”

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