The Monetary Policy Committee (MPC) is likely to maintain its GDP growth forecast similar to the levels in June policy at 9.5 percent with risks broadly balanced amid improving agri output, strong rural demand (even though not fully insulated) and better adapted firms, stable financial conditions and global growth spill overs and new risks in the form of delta variant or third wave/slower vaccination drive.
However, they are likely to maintain that growth is sub-potential and the scarring impact of Covid would only accentuate the output gap further.
Amid two inflation surprises in May and June, the Q1FY22 inflation has overshot RBI's forecast and could lead the MPC to raise its FY22 expectations marginally from 5.1 percent (Emkay:5.35 percent). However, the MPC is likely to reinforce Governor Das' view that inflation has a transitory hump led by supply side bottlenecks. With inflation likely to be sub-6 percent going ahead, the MPC may harp on accommodative stance as it would again fall within the flexible target range. We note there were some emerging dissents in MPC minutes on inflation risks, but we still think that the chances of a split vote on accommodative stance are low in upcoming meeting.
Yield curve management to remain policy focus
The last MPC policy in June focused largely on the yield management as the RBI tried to reinstate its stance on liquidity and sovereign premia by enhancing the GSAP 2.0 to Rs 1.2 lakh crore for Q2FY22. The RBI has been intervening (directly/indirectly) at different segment of the yield curve since July, with an aim to target orderly evolution of the yield curve as the policy strategy of being anchored only at 10-year yield partly became counter-productive.
However, we reckon that amid heavy supply each week, the tussle between the markets and RBI has continued, with markets showing their discomfort with RBI's choice of papers for Government Securities Acquisition Programme (GSAP) and devolution of papers at cut-off yields uncomfortable to the RBI. We could see RBI reiterating its support for the bond market and also indicate that they do not necessarily target any level or segment of the yield curve. However, RBI will likely hint at their preference for lower sovereign risk premia ahead and to strive fixing artificially skewed yield curve.
Communication on liquidity management key amid evolving market risks
The RBI has been contending with dilemmas on managing its liquidity stance since Covid first struck last year amid robust forex flows and elevated inflation pressure. The surplus liquidity has not necessarily percolated well across the curve or segments of the rates market as asymmetric gains in credit markets. This also raises the risk of rerouting of surplus liquidity and excessive risk taking in other asset classes, specifically equities.
However, RBI's tryst with liquidity normalization with variable rate reverse repos (VRRRs) has not been very successful in the past (end-Q3FY21) and had led to shock across the G-sec curve, more pronounced at 3-5 year segment. The RBI reaffirmed longer tenor VRRRs in April as the first step towards normalization. While they may restate this, we are unlikely to hear any action of liquidity normalization in the upcoming policy. The policymakers would tread cautiously on this front to see orderly evolution of yield curve having seen extreme market reactions in the past.
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