The RBI MPC, possibly with three new members, will likely adopt a wait-and-watch approach for its policy rate decision on October 1. On the regulatory front, too, the RBI would likely prefer to wait to see how the debt resolution plan progresses.
Liquidity measures are already in place, however, the recent GSec auctions as well OMO operations are symptomatic of the strains in yield management.
Some deliberation is warranted on how to manage yields considering the simultaneous occurrence of excessive FX flows and bond supply, and elevated inflation.
We expect the MPC to keep rates on hold in the October policy. In the inflation-targeting framework, the MPC is facing three-quarters of 6%+ average inflation which requires RBI to write an explanatory letter to the government.
While the inflation upside may not have much to do with the conduct of the monetary policy, it is not something that the MPC can gloss over.
The MPC does have some space to reduce rates further—after the inflation trajectory starts to dip again from November/December—possibly in 4QFY21.
We expect the RBI’s comfort level on inflation to be closer to 5% keeping in view the wide output gap due to the pandemic.
However, while incremental efficacy of rate cuts will be low in the real economy, it could be of substantial help in signaling lower yields.
Going into 2HFY21, yield management will be important with risks of higher government borrowing weighing on the market. However, yield management becomes difficult given the existing liquidity surplus and continuing FX inflows.
With downside risks to growth persisting, as COVID cases continue to surge, the need for further fiscal support and, hence, RBI’s support to bond market becomes more compelling.
The dilemma becomes starker as inflation remains above 6 percent, restricting RBI’s ability to infuse liquidity (at least in principle). The RBI has been shy in announcing OMO purchases.
Till now, it has preferred to conduct OMOs to twist the yield curve and keep a tab on the long term yields. The regulatory relaxation in the HTM limit has yielded some results. However, the visibility of sustained support from RBI would help in accelerating the process.
Beyond the MPC’s remit, the RBI would be watchful of how the debt resolution plan pans out (announced in the last policy). Some of the measures announced by the government in May are also progressing steadily.
However, as is the case with most other economies, the need for growth revival is squarely on the fiscal space. The monetary space is more of an enabler to ensure the system is well greased.
The RBI has certainly played its part and the incremental space (without unconventional measures) is relatively small. The fiscal needs to take up a larger space, temporarily, in order to generate a less painful recovery.
(Suvodeep Rakshit is Senior Economist in Kotak Institutional Equities)Disclaimer
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