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Why has the RBI not lowered its GDP and Inflation estimates for FY23?

Current interest rate hike likely to have adverse impact on FY23 GDP, going by RBI's estimate of monetary policy transmission period

August 05, 2022 12:46 IST | India Infoline News Service
In its MPC meeting today, RBI has raised repo rate by 50 basis points to 5.4%. One basis point is .01%. Repo rate is the rate at which RBI lends to banks. It acts as the effective benchmark interest rate in India. The interest rate that banks charge from their borrowers is based on the repo rate. 

RBI has also increased Standing Deposit Facility (SDF) rate to 5.15% from 4.65%. SDF is the rate that RBI pays to banks when they deposit their excess liquidity with it. By raising SDF too, RBI is trying to give a further push up to interest rates.

Marginal Standing Facility (MSF) rate has been increased to 5.65% from 5.15%. MSF is the rate that RBI charges from banks when they do overnight borrowing from it. If banks have to pay a higher interest rate to RBI for overnight borrowing, it is expected to translate into banks charging higher interest rates from their borrowers.

Bank rate has been increased to 5.65% from 5.15%. Bank rate is the rate that RBI charges from banks when they borrow from it for a longer tenure.

In spite of these interest rate hikes, RBI has not changed India’s GDP growth forecast for FY23. It has retained its GDP growth forecast for FY23 at 7.2%. It has also not changed its forecast for inflation for FY23. It has maintained that inflation for FY23 is expected to be at 6.7% as was previously estimated.

These estimates have not been changed probably because of the monetary policy transmission period. Monetary policy transmission period is the time it takes for any monetary policy action to become effective at the ground level. RBI’s own estimate says that in the case of India, transmission period for any monetary policy action for GDP is between two and three quarters and in the case of inflation it is between three and four quarters. This means that an interest rate change today is likely to start impacting GDP two or three quarters from now. An interest rate change today is likely to start impacting inflation three or four quarters from now.

We are at the beginning of the second quarter of FY23 now. The hikes today should start impacting GDP by the fourth quarter of FY23. Similarly, they should start impacting inflation by 1st quarter of FY24. Even though the RBI has not changed its GDP estimate for FY23 today, there is a good chance that the hikes today will have negative impact on GDP of FY23.

Regarding their impact on inflation, it will be difficult to say anything. This is because the current inflation is supply side driven one rather than demand side driven one. It has been caused by numerous supply side disruptions seen in the last two years due to Covid restrictions. The Russia-Ukraine war has further exacerbated these supply side disruptions in many areas. Monetary policy is not very effective in impacting supply side inflation.

RBI also had to increase interest rates so that the rupee does not slide further. There is no guarantee that after this increase in interest rate, rupee will not depreciate further against the dollar. But because the Federal Reserve has increased interest rates aggressively, and if the RBI does not increase interest rate in response, flow from rupee to dollars would have increased further. This would have put further pressure on the value of rupee against the dollar.

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