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Saturday, January 28, 2023

Tackling inflation with accommodation

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A slowing pace of interest rate increments by the Reserve Bank of India (RBI) was received with equanimity by the bond and currency markets. The stock market dipped before recovering in the absence of any guidance by the central bank that the battle against inflation was more or less done, although RBI governor Shaktikanta Das admitted the worst was behind us. Alongside a 35-basis-point (bps) hike in the policy repo rate, RBI has marginally raised its projection for inflation in the current quarter and the next, while lowering, again marginally, its estimate for GDP growth. Global spillovers are squeezing India’s economic momentum, according to Das, and core inflation is stubborn.
A cumulative 2.25-percentage-point increase in the repo rate during 2022 is an incredibly steep climb compared to RBI’s previous interest rate upcycle. Yet, adjusted for inflation, the current policy rate remains accommodative as RBI negotiates a soft landing for the economy. It can claim success in this endeavour with GDP growth projections being pulled down by 1 percentage point over the course of 2022. Inflation, however, is expected to stay above the target 4% over the next 12 months, by the central bank’s admission. System liquidity is in surplus except for episodic tightening on account of currency demand and tax outgo. The accommodation is permitted by improved monetary transmission and allows RBI space to offer banks a softer cushion to absorb losses on their government bond holdings during a rate tightening cycle. This should keep government borrowing for capital expenditure on track.

Exchange rate intervention has delivered an appreciation of the rupee in real effective terms between April and October. India has been through an energy crisis without severe loss to its import cover. Capital flows have not been inordinately affected with portfolio investment recovering, direct investment stable and remittances robust. On balance, the persistence of inflation is outweighed by the growth dividend that RBI has sought to preserve.

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