Following on the heels of a 40 bps hike in repo rate announced in an off-cycle meeting in early May-22, RBI raised the policy rate further by 50 bps to 4.90% in its scheduled policy meeting in Jun-22. The quantum of hike was however marginally higher than market expectations pegged at 40 bps. With this, the SDF and MSF rate i.e., the lower and upper bound of the LAF corridor stand adjusted to 4.65% and 5.15% respectively.

The 50-bps rate hike was unanimous, backed by all members of the Monetary Policy Committee (MPC) who decided to "remain focused on withdrawal of accommodation to ensure that inflation remains within the target going forward, while supporting growth”.

Looking back, the RBI has progressed swiftly on the rate tightening cycle in a short span of two months given the sharp pickup in CPI inflation over the months of Mar-22 and Apr-22.

• Recall, in Apr-22 MPC opted for a one-shot normalization in the width of the policy rate corridor from 90 bps to 50 bps while replacing the reverse repo rate by the SDF, introduced at 3.75%.
• In May-22, in an inter-meeting move, the MPC raised repo rate by 40 bps to 4.40%, thereby resulting in the MSF and SDF rates to adjust upwards to 4.65% and 4.15% respectively. In addition, the RBI had also announced a 50 bps increase in the CRR to 4.50% of bank’s NDTL (net demand and time liabilities).
• With Jun-22 action, the cumulative repo rate hike now stands at 90 bps

RBI’s forecasts for FY23

With respect to FY23 economic outlook

• RBI retained the GDP growth forecast at 7.2%, with risks evenly balance. On a quarterly basis, it estimates growth at 16.2% in Q1, 6.2% in Q2, 4.1% in Q3, and 4.0% in Q4.
• On CPI inflation, RBI revised up its FY23 forecast sharply by 100 bps to 6.7%. Recall, RBI had raised its FY23 inflation projection by 120 bps to 5.7% in Apr-22 review. As such, effectively in a span of 4 months, inflation projection has seen an upward reset of 220 bps.
• On quarterly basis, the forecasts for FY23 now stand revised to 7.5% in Q1 (from 6.3% earlier), 7.4% in Q2 (from 5.8% earlier), 6.2% in Q3 (from 5.4% earlier), and 5.8% in Q4 (from 5.1% earlier). Effectively, this implies that the headline inflation will remain well above the 6.0% upper band of MPC through calendar 2022.

Key takeaways and outlook

On growth, MPC believes that India’s economic recovery remains on track. RBI’s survey on Capacity Utilization (CU), indicates further improvement to 75% in Q4 FY22, which along with Government’s capex focus and strong imports of capital goods augurs well for investment pickup. In addition, prospects of a normal monsoon along with rebound in contact intensive services (full vaccination coverage at over 70% of population) should prove supportive, despite headwinds from geopolitical tensions, elevated global commodity prices, rising input costs, tightening of global financial conditions, and slowdown in global economy. As such, RBI has retained its growth forecast at 7.2% for FY23, marginally lower than our estimate of 7.5%.

On inflation front, RBI’s upwardly revised estimate at 6.7% is only a tad higher than our projection of 6.5%. Yet to reflect complete pass-through of global commodity prices, hike in electricity tariffs in some states, continuing trade and supply chain bottlenecks and a flare up in crude oil price above USD 120 pb yet again are likely to keep price pressures intact in the coming months.

Having said so, we acknowledge the impact of government measures on inflation – especially the second cut in excise duties on petrol and diesel by Rs 8 and Rs 7 per litre respectively, that are estimated to have a direct impact of ~25-30 bps on lowering inflation. In addition, the reduction in duties on raw materials for steel and plastic industry, edible oils and ban on wheat exports should help contain second-order dispersion of inflationary pressures.

On monetary policy outlook, we continue to expect the MPC to remain in "withdrawal of accommodation” mode in order to -

• Tackle the elevated CPI inflation, which as per RBI’s own assessment is likely to remain above the 6.0% policy threshold for four consecutive quarters (i.e., Q4 FY22 until Q3 FY23). This will imply a breach of the monetary policy mandate in the current fiscal.
• The ongoing aggressive normalization in monetary policy by key central banks globally along with the Ukraine-Russia crisis is creating pressure on EM currencies including INR. Rupee has depreciated by more than 4.0% since the start of 2022. While FX reserves remain adequate, synchronous interest rate adjustment with rest of the world would help to rein in adverse external spillovers.

As such, we now expect cumulative 150-200 bps hike in FY23 taking the repo rate higher to the range of 5.5%-6.0% by end FY23, above the pre-pandemic level of 5.15%. The front loading of rate action will continue to be in sync with the aggressive monetary policy normalization in several countries, led by the US.

Meanwhile, we expect the central bank to continue to wean off excess liquidity from the system as core liquidity surplus remains close to 3.8% of NDTL as of end May-22. This is quite high compared to RBI’s own estimate of 1.5% level being non-inflationary (as per the Currency and Finance report). For liquidity withdrawal, while an additional CRR hike of 50 bps remains our expectation, alternate tools via fx intervention, sale of g-secs or issuance of short-term cash management bills can also be deployed to achieve the same objective.

With the swifter and stronger policy normalization now underway (also globally), we now revise our expectation of 10Y g-sec yield to 8.00% before the end of FY23, from 7.75-8.00% range earlier. Having said so, we do expect the central bank to rely on tools like Operation Twist and verbal suasion, to support yields and ensure an orderly completion of government’s record high borrowing program in FY23.