By August, Peak Repo Rate Would Reach 5.5%-5.75%, above Pre-Pandemic Level: SBI
Moneylife Digital Team 09 June 2022
Even as global uncertainties are in abundance, growth numbers continue to show optimism locally, and the Reserve Bank of India (RBI) could factor in a rate hike in August and even October policy, and take it higher than the pre-pandemic level by August to 5.25% and in October to 5.5%, says a research note.
In the report, Dr Soumya Kanti Ghosh, group chief economic adviser of State Bank of India (SBI), says, "With the dropping of 'accommodative stance' and stress on 'withdrawal of accommodation', RBI has given clear forward guidance that withdrawal of liquidity will be the preferred option in combating inflation. With inflation now projected at 6.7% and crude oil prices average increased to US$105 per barrel (bbl) from US$100 a bbl and existing further risks to inflation trajectory, we believe that RBI is likely to hike the rate both in August and October policy taking the repo rate to 5.25% in August and 5.5% in October. Our peak rate at the end of the cycle now has a lower bound of 5.5% and could go up to 5.75% depending on the inflation trajectory. This is purely data-dependent and subject to revisions."
However, SBI says it believes the 10-year yields are likely to be capped at 7.5%, even assuming a 175 basis point (bps) spread over the peak repo rate at 5.75%. "This is because term premium is likely to be 50 bps, factoring in a further market adjustment of 50 bps over and above 5.75% as an insurance rate hike and an additional 75 bps because of supply overhang. This makes the total spread of 175 bps over 5.75%. Interestingly, the pre-pandemic spread was around 135 bps," the report says. 
As widely expected, RBI's monetary policy committee (MPC), in its June review, unanimously decided to increase policy repo rate by 50bps to 4.90%, while also remaining focused on 'withdrawal of accommodation' to ensure that inflation remains within the target, going forward, all the while supporting growth. 
RBI has retained its real gross domestic product (GDP) growth forecast for FY22-23 at 7.2%, with risks broadly balanced. However, the inflation projection for FY22-23 has been revised upwards by 100 bps to 6.7% on account of several factors, including tense global geopolitical situation, elevated commodity prices, adverse global supply conditions and heightened crude oil prices. 
The average crude oil price (Indian basket) assumption is now taken at US$105/barrel from US$100/barrel. With the recent average 6% minimum support price (MSP) hike for the kharif crops, there will be an upside pressure of 15bps to 20bps on inflation, SBI says.  
In terms of liquidity, according to the report, RBI has done a smart job and, currently, the net liquidity adjustment facility (LAF) has declined to Rs3.2 trillion from Rs5.54 trillion as on March-end. Core liquidity has also declined to Rs7.1 trillion from Rs8.3 trillion, of which government cash balances is at Rs3.5 trillion. 
"We believe as the government starts to spend towards the later part of the year, this may necessitate a cash reserve ratio (CRR) hike more as a policy tool to support open market operations (OMO) at a later date when the government borrowing picks up pace," the report says.   
According to SBI, the regulatory changes announced by RBI have mainly focused on increasing credit to the construction and housing sector and some announcements in payments systems and margin requirements for non-centrally cleared derivative contracts. 
The increase in limit on individual housing loans by cooperative banks and permitting rural cooperative banks (RCBs) to extend finance to 'commercial real estate - residential housing' within the existing aggregate housing finance limit of 5% of their total assets will provide the necessary push to credit flow to the housing sector. 
Additionally, SBI says linking RuPay credit cards (CC) to unified payment interface (UPI) is expected to provide more avenues and convenience to 15mn (million) customers in making payments through the UPI platform.
Meanwhile, the governor has also alluded to the proactive role that fiscal policy can also play in unison with monetary policy as a coordinated attempt to control inflation. "This could be achieved with state cutting value-added tax (VAT) on fuel as a policy option to anchor inflationary expectations. Interestingly, economic literature suggests that a monetary policy contraction accompanied with fiscal policy expansion is the ideal coordinated policy outcome with the maximum payoff," SBI says. 
The policy also highlighted the global uncertainty with countries grappling with multi-decadal high inflation and slowing growth, persisting geopolitical tensions and sanctions, elevated prices of crude oil and other commodities and lingering COVID-19-related supply-chain bottlenecks. 
As per World Bank's latest assessment, global growth is expected to slump to 2.9% in 2022 from 5.7% in 2021—significantly lower than 4.1% that was anticipated in January. The Russian invasion of Ukraine has magnified the slowdown in the global economy which is entering what could become a protracted period of feeble growth and elevated inflation. 
However, SBI says the good thing is that even as global uncertainties are in abundance, growth numbers continue to show optimism locally. "Capacity utilisation rates have now moved up to 74.5%, with new investment announcements at a record high of Rs20 trillion in FY21-22 and the manufacturing sector leading from the front. This will give more comfort to RBI in pushing through the rate hikes and controlling inflation as its primary and foremost option," it added.
2 months ago
1 The peak interest rate estimate of 5.5-5.75% are not convincing if we compare it with the inflation rate estimate by RBI of 6.2 and 5.8% for Q-3 and Q-4 as it may be difficult to tame the inflation with negative real interest rates. Moreover, if we consider the upward revision in the inflation estimate by RBI from Feb to Apr and then from Apr to June, the peak rate estimate become further non-convincing.

2 As we keep on pumping out more and more oil from the non-Russian sources, the spare capacity is also getting depleting and any disruption in the production anywhere in the world for any reason including technical, political or cyclone may lead to panic and disproportionate increase in the oil prices, which may further fuel the inflation expectations.
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