RBI hiked the policy repo rate by 50 basis points (bps) to 4.9 per cent in its second monetary policy statement for 2022-23 announced on June 8. The hike was no surprise as it was widely anticipated by market participants that the RBI would be raising repo rate to curb the persistent rise in inflation. Two weeks ago, the RBI governor had stated that a rate hike in the June policy statement was a no-brainer. The unknown was only about the quantum of the hike. Most experts anticipated a hike in the range of 25 to 50 bps. Even after the hike of 50 bps, policy repo rate continues to remain below the level before the pandemic when it was at 5.15 per cent.

This is the second hike in repo rate during the current fiscal year. In a surprise move on May 4, the RBI had announced a 40 bps hike in repo rate to 4.4 per cent in an off-cycle policy announcement. This came after a hiatus of 2 years during which RBI had maintained a status-quo on policy repo rate.

The policy statement clearly mentions a withdrawal of the RBI’s accommodative stance to pull back inflation within the target band. This is expected to be done to through variable rate reverse repos (VRRRs) of longer durations as the RBI has refrained from any CRR hike to immediately reduce liquidity from the system. In its May 4 off-cycle announcement, the RBI had hiked CRR by 50 basis points to 4.5 per cent. This was expected to reduce liquidity in the system by Rs.870 billion. Banks had urged the RBI governor not to hike CRR as it would reduce liquidity quite sharply and affect the nascent recovery in credit growth. In the month following the last CRR cut, average daily surplus liquidity, as measured by absorption amount under VRRRs and standing deposit facility (SDF), dropped to Rs.4.6 trillion from Rs.6.2 trillion in the first three weeks of May. In 2022, average daily surplus liquidity had hit a high of Rs.8 trillion in February.

A factor that could have weighed heavily on the RBI’s decision to hike repo rate is the rapidly depreciating exchange rate of the Indian rupee against the US dollar. The falling stock market indices and continuous outflows of FPIs from equity as well as debt have led to the weakening of the exchange rate. On June 8, the rupee hit the lowest level at Rs.77.72 per US dollar. From Rs.74.51 per US dollar in November 2021, average INR/USD exchange rate dropped to Rs.77.32 in May 2022. This is a depreciation of 3.6 per cent. A rapidly depreciating rupee further increases the prospects of imported inflation at a time when global commodity prices, including energy prices, are not showing any signs of easing.

The RBI has revised its 2022-23 inflation forecast upwards to 6.7 per cent from its previous forecast of 5.7 per cent. Till the third Quarter of fiscal 2022-23, RBI expects inflation to be higher than the upper band of 6 per cent of its target inflation rate. The hike in its inflation projections is also likely to have prompted the RBI to hike repo rate. It also implies further rate hikes in the coming policy announcements.

The latest increase in repo rate will lead to another round of hike in lending rates by banks. The rate hike will get transmitted soon as the rates on almost 40 per cent of floating rate linked outstanding rupee loans of SCBs are linked to external benchmark which is the repo rate. Banks have also started hiking lending rates based on marginal cost of funds based lending rates (MCLR). On June 7, HDFC Bank hiked MCLR by 35 basis points.

Yield on government securities with 10-year residual maturity is on a continuous northward journey. Each monetary policy announcement has led to a spike in gsec yields. From 6.91 per cent on 7 April, gsec yield spiked to 7.16 per cent on 11 April, after the SDF rate was introduced above the reverse repo rate in the first monetary policy announcement for 2022-23. The off-cycle repo rate hike of May 4, recorded a sharp reaction. From 7.12 per cent on May 2, yield surged to 7.4 per cent on May 5. On June 7, yield had gone up further to 7.52 per cent. On June 9, 10-year gsec yield eased to 7.48 per cent. But yields are likely to rise in the coming weeks.

From a low of 3.13 per cent in the week ended February 4, weighted average call money rate (WACR), the operating target of monetary policy, rose to 3.38 per cent in the week ended April 8. It has been rising ever since and has hit 4.05 per cent on June 3. But throughout the rising trajectory, it remained below the SDF rate, indicating the large surplus liquidity in the system. Call money rates will move higher as the RBI’s withdrawal of accommodation further reduces surplus liquidity in the system.