The Reserve Bank of India’s monetary policy committee held key policy rates on Friday, as widely expected by economists and analysts, and maintained its accommodative stance (with one dissent, again as expected). There was no hike in the reverse repo rate, which some market segments seemed to have been pricing in.
The communication, moreover, was only mildly hawkish, but has started preparing markets for an inevitable start of formal normalization, which is now consistent with India’s growth-inflation dynamics. The outlook is one of watchful vigilance, particularly on core CPI inflation. However, the mantra is “gradualism”; as the central bank governor Shaktikanta Das pithily said, “Don’t rock the boat when the shore is approaching.” The senior management at the RBI has communicated the intent to follow glide paths, not crash landings, in the normalization process. The approach overall is quite risk averse, opting to wait till “growth becomes quite entrenched”.
There were some signals in the communication, though, that markets are being prepared for an imminent normalisation. A “whatever it takes” tone for monetary policy support is implicitly retained: “continue to maintain an accommodative stance as long as necessary to revive and sustain” growth.
The growth-inflation tradeoff dynamics were judged to be consistent with a policy hold. The RBI maintained its earlier 9.5 percent FY22 growth forecast (which is the same as ours as well), but portents of strong domestic recovery are offset by potential global commodities and financial markets volatility, balancing the risks to the growth outlook. There are downside risks, given rising supply-oriented dislocations.
Developments in China remain a big concern, with the potential to disrupt the global recovery and with adverse effects on India’s exports. Overall, signals from high-frequency activity indicators are still mixed, the current recovery is “uneven” and the interactions of supply dislocations and demand weakness remain blurred.
The CPI inflation forecast was reduced from the earlier 5.7 percent to 5.3 percent. However, the evolving risks of a sticky “core” (non-food and fuel) inflation versus weak demand conditions “required close vigilance”. Global prices remain elevated across the board—food, metals, ores, energy, freight and logistics—all of which have the potential to feed into domestic costs and prices. Price pressures should probably no longer be considered “transitory”. Despite these persistent risks, we think CPI inflation will broadly follow the glide path projected by the RBI for a gradual decline to around 4 percent by March 2023 or a little later. Still, low capacity utilisation levels provide room for output increases without the system overheating. We maintain an average 5.2 percent inflation for FY22, with upside risks from commodities plus domestic services prices after a full opening up and vigorous recovery.
But the broadly accommodative tone of the statement was offset by the only true surprise of the policy: the complete withdrawal of the government securities acquisition programme (G-SAP). We had anticipated a cutting back of the programme, or folding future open market operations or quantitative easing under Operation Twists into the G-SAP, but not a full withdrawal. This action, designed to reduce the endogenous, or voluntary, infusion of liquidity is effectively the RBI’s version of tapering.
So how might the normalisation process go forward from here? The RBI has consistently demonstrated a well thought, data driven, sequencing of steps to ensure an “orderly borrowing programme [and] an orderly evolution of the yield curve as a public good”. This modus operandi is likely to continue. The crucial first steps will be active management of both the quantum and price of the surplus system liquidity (currently Rs 8.5 lakh crore and likely to progressively increase). The halt of the G-SAP and the larger VRRR or variable rate reverse repo offers (with additional fine-tuning operations as required), will help manage the quantum. The pricing of VRRR auctions will give direction to short-term rates. The cutoff yield at Friday’s 14-day VRRR auction, for instance, was a high 3.99%. The yields at the ongoing G-Sec and state development loans auctions will shape the yield curve at the medium and longer maturities.
In summary, the role of monetary policy will now largely be the smoothening of financial sector volatility arising largely from the imminent normalization steps of global central banks, and flanking support to maintain financial intermediaries’ stability while incentivising credit growth. Periodic communication of a gradual, calibrated tightening post normalisation will smooth out this volatility.
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