Five of the six MPC members voted on maintaining the stance as accommodative.
It is now common knowledge that the RBI is going to hike interest rates in 2022, and the ‘why’ part of it is known. On the ‘how much’ part of it, there is a question mark. On this, the RBI is the best judge. From our perspective, let us look at the approach the RBI is likely to take on interest rate hikes.
Deciding interest rate trajectory
There are three defined approaches to interest rate policy: (1) accommodative, which means the central bank has a preference for lower interest rates to help the growth of the economy; (2) hawkish, which means the preference is to have relatively higher interest rates to slow down growth and contain inflation; and (c) the one in between, i.e., neutral. The current stance is not just accommodative, but super-accommodative. In the coming days, we will not only see higher interest rates, but change of stance from accommodative to neutral.
When the minutes of the previous meeting of the Monetary Policy Committee (MPC) held on December 8, 2021 was published recently, there was a change in their ‘language,’ i.e., statements given by the six members of the MPC. While all the six members voted in favour of keeping the repo rate unchanged, five members voted on maintaining the stance as accommodative and one member expressed reservations on the accommodative stance. This is an indication of the stance gradually changing to neutral.
Still supportive of growth
Even when the stance officially shifts to neutral, the approach of the RBI will remain supportive of growth of the economy. The reason is, though the economy is coming back on track, it is happening on a low base. The meaning of low base is, GDP growth is measured by comparing the output in a period with that of corresponding period previous year, which is called year-on-year (y/y).
To give an illustration of this ‘base effect’, in the quarter April-June 2020, GDP sank miserably, due to pandemic and lockdown, which created a low base for GDP growth in the quarter April-June 2021. In the quarter April-June 2021, GDP growth was buoyant, but that was more of a headline number as it was on a very low base. In the quarter April-June 2022, GDP growth will be high, as the base is still low in the real sense. However, the RBI is aware that the real traction on growth is yet to come back and still requires the support of low interest rates.
Where does this take us? Rate hikes will happen, as we cannot have super-low interest rates forever. Bank depositors are receiving real negative interest rates, net of inflation. However, the rate hike cycle will not be steep or long, as the economy still requires the support of low interest rates. Money at lower rates induces people to take more loans, which means more economic activity, and growth. That is the essence; interest rates will be corrected upwards from super-low levels to reasonable levels, but will still be supportive of people availing of loans – for industry, other commercial purpose, consumption, etc. Then, the question is, what is supportive and not high.
Guessing the quantum of rate hikes
Again, the RBI is the best judge, but let us get a sense. We will talk of the repo rate, the rate at which the RBI lends to Banks for one day if they require money, as that is used as a signal rate to influence interest rates across the economy. Since 2000, taking a simple average of the prevailing repo rate, without taking the weightage of the time period for which a particular rate existed, it is 8 percent. Currently, the repo rate at 4 percent, is the lowest ever. Comparing with the historical average of 20 years is not fair, as inflation in earlier days used to be higher than these days and accordingly the signal interest rate also had to be high. Nonetheless, it gives a perspective that today it is the lowest ever.
How much the RBI will hike is anybody’s call, but for the sake of discussion, over the next year or so if they hike the repo rate by say 0.75 percent to 1 percent to bring it to 4.75- 5 percent, then interest rates would have been normalized. This is still supportive as mentioned earlier, and not prohibitive. If you have availed of floating rate loans, be prepared for some upticks over the next year or so, but the RBI is not out there to make life difficult for you but acting in the overall interest of the economy.