In trying to squeeze one last drop of output from an empty barrel of monetary elixir, India's central bank made the serious mistake of not only ignoring the country's inflation buildup, but pretending that it didn't exist. Now that the Reserve Bank of India has surprised the market with an unscheduled, 40 basis point increase in the benchmark rate, the journey to recoup its lost credibility is finally under way. Chances are, it will be a hard slog. While the tightening campaign is unavoidable, the longer it goes on, the more it will annoy politicians.
Even the U.S. Federal Reserve seriously underestimated the inflation risk last year, and has to play catch-up. The RBI's policy errors are more recent. The central bank blew its February meeting by projecting price increases for the financial year ending in March 2023 at a benign 4.5%. The monetary policy committee put its faith behind that cheery forecast even though the bond market didn't believe it one bit: Private-sector estimates were by then already starting to coalesce around the top end of the central bank's 2%-6% target inflation range. Still, traders took the official forecast as a signal that the RBI was going to ignore price pressures just to keep borrowing costs low for the government and give a helping hand to a still-incomplete recovery from Covid-19.
However, by the time the February inflation reading came in at 6.1% — higher than the previous month's 6% and outside the tolerance range — Russia's invasion of Ukraine had begun. If the RBI was behind the curve before the war, it wasn't close to being on the right route after it.
After consumer prices rose nearly 7% from a year earlier in March, Nomura Holdings Inc. raised its forecast for rate increases by the third quarter of 2023 to 200 basis points, up from its previous estimate of 150. The terminal rate for the RBI's repo rate would be 6%, economists Sonal Varma and Aurodeep Nandi said. After Wednesday's increase, which took the Indian benchmark to 4.4%, Nomura changed its terminal rate estimate to 6.25% by the second quarter of next year. The longer you delay normalization, the more of it you end up doing.
Prime Minister Narendra Modi's government will not like short-term rates to go up all the way to 6.25% because that could mean long-term sovereign bond yields of 8% or more, something India hasn't seen on a sustained basis since the aftermath of the 2013 taper tantrum. (The 10-year yield surged to almost 7.4% after the unexpected RBI move.) Higher interest rates may complicate the financing of a record $200 billion government borrowing program, bigger than even in the first year of the pandemic. Costlier capital could also pour cold water on a recovery in private investment that policy makers have been desperately waiting for.
It's catch-22. Trying to stoke weak demand with artificially low rates could have eventually threatened external stability. Foreign investors have pulled out more than $17 billion so far this year from the Indian equity market. The $600 billion in foreign-exchange reserves may shield the currency from the intense selling pressure it witnessed after the Fed's 2013 taper. Even so, a widening current account deficit, combined with the RBI's reluctance to raise rates, hasn't exactly inspired confidence in rupee assets. The Nifty index of top 50 stocks was trading at 22 times forward earnings at the start of the year; that valuation has since shrunk to 19 times earnings. Yet global investors are refusing to bite.
Inflation hurts the poor and the middle-class more than it affects the rich. It also squeezes the smaller firm that isn't able to absorb higher commodity costs the same way that a large company can by sacrificing overhead. Many of India's small- and midsized enterprises have only survived the pandemic with the help of government-guaranteed emergency loans. Now that the RBI has stopped being in denial about prices, the more vulnerable producers and consumers will expect it not to stop prematurely. Let the government do its best to protect growth while managing its finances. The central bank has to go back to fulfilling its inflation mandate.