Why the Inflation Forex Trap Leads to Rate Hikes | Mint – mint | Jewelry Dukan

Inflation in India has been above the central bank’s upper tolerance limit for eight months now. But when the Monetary Policy Committee (MPC) hikes rates next week, rising prices won’t be the only reason. This year the rupee has depreciated both domestically through inflation and abroad through depreciation against the US dollar. The two factors have complicated the MPC’s task of maintaining financial stability in a volatile global scenario. Let’s unpack.

So far this year, the rupee has fallen to 79.8 from 74.5 per dollar, down nearly 7%. At the same time, consumer prices have risen by around 6.8% on average. Why is that important? The domestic and external values ​​of the rupee are interlinked and complementary: a prolonged period of high and rising inflation weakens the rupee by hurting India’s growth and competitiveness, and a falling exchange rate triggers inflation via higher import prices. India, which imports almost all of its crude oil, is particularly at risk of being caught in this inflation-exchange rate loop.

The central banks of almost all emerging and industrialized countries have raised interest rates this year. With the rupee hovering near the psychologically sensitive 80 level, the MPC may have no choice but to follow it even as the world grapples with fears of an imminent recession. A fourth straight repo rate hike by the MPC – likely in the range of 35-50 basis points (bps) – seems a foregone conclusion. (A basis point is one hundredth of a percentage point.)

Rupee Dynamics

The reasons for the depreciation of the rupee can be divided into two categories: factors that mainly drive up domestic prices and those that mainly affect the foreign exchange markets. The first category included the rise in food and fuel prices following the Russian invasion of Ukraine, the rise in input prices and pent-up domestic demand for services.

The FX market was mainly driven by rising US interest rates. As yields on US assets – already attractive given its safe-haven status – rose to their highest levels in decades, there was a massive shift of global capital into dollar assets. This strengthened the dollar and, as a corollary, weakened the rupee.

Persistently high inflation in the US means the US Federal Reserve may hike interest rates further, even as inflation differentials between India and the US narrow. Under such circumstances, a further rate hike by India will help attract foreign investment and consequent dollar inflows, which will support the rupee.

rupee and inflation

Typically, everyone who trades foreign exchange faces more or less the same exchange rate at any given point in time, but each household faces a different level of inflation based on its specific consumption needs. But this time, broad-based inflation in food, fuel and services has ensured the pinch has been more secular.

The RBI recognizes a close link between the devaluation of the rupee and inflation: an April 2022 monetary policy report said that a 5% devaluation could push inflation up by 20 basis points. Not surprisingly, the RBI regularly intervenes in the FX markets to “manage” the exchange rate. This is especially important now that much of the inflation can be attributed to external events.

The RBI governor recently made it clear that the central bank is in the market almost daily not only to control volatility but also to anchor expectations of rupee depreciation. A stronger rupee will make imported inputs cheaper and curb inflation to some extent.

export starch

Due to the current global uncertainties, it is difficult to predict if and how much the rupee will continue to depreciate. A comparison with peer currencies shows that the rupee’s depreciation this year is in the top quartile of this group. Currencies supported by commodity exports (such as those of Malaysia, Brazil and Indonesia) depreciated less as their values ​​were boosted by higher commodity prices. The currencies of export-oriented economies (such as South Korea and Thailand) fell more as their growth is likely to be hampered by a slowdown in the west.

India has the advantage of being driven by domestic consumption but faces the challenge of being a net importer of commodities. The King Dollar’s bullish march threatens to bring repeats of the inflation-exchange rate loop. In this context, an RBI rate hike, while not effectively breaking this loop, will definitely weaken its impact in the short term.

Deepa Vasudevan is an independent economics and finance writer.

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