Monetary Policy | RBI has stepped up its preparedness to combat inflation

Against the complex economic backdrop prevalent at present, the Reserve Bank of India (RBI)’s decision to retain the accommodative stance and spelling out plans of gradual withdrawal of accommodation was no major surprise. Keeping the repo rate unchanged at 4 percent was also nearly certain. However, introduction of the standing deposit facility (SDF) at 3.75 percent by the RBI was an important and interesting decision. While the ‘traditional’ reverse repo rate (now termed as the fixed rate reverse repo/FRRR) was kept unchanged at 3.35 percent, it will likely have negligible significance in near future as, effectively, the SDF will now act as the floor for the liquidity adjustment facility (LAF) corridor.

Still, this move itself should not lead to any knee jerk upward pressure on near term rates given that the latter already settled close to the repo rate (that is distinctly above the SDF rate) as the RBI focused more on variable rate reverse repo (VRRR) in recent months. Moreover, while most market participants did not expect the entire 40 basis point narrowing of the LAF corridor to take place in one shot, admittedly the eventual outcome of restoring the usual width of the LAF corridor had been well telegraphed by the central bank.

At a time when inflation is rising and geopolitical tensions are leading to volatility in global markets and keeping energy and commodity prices elevated, the RBI has been bold and upfront in recognising the risks to growth and inflation in FY23. While the lowering of the GDP growth projection for FY23 by 60 bps may appear large, in reality, further downside risks to the current forecasts of 7.2 percent cannot be ruled out. Similarly, while the upward revision of 120 bps for FY23 average CPI may appear large, the current forecast of 5.7 percent is certainly closer to reality, as the previous forecast of 4.5 percent was way too conservative even without the geopolitical conflicts that erupted after the February meeting of the monetary policy committee (MPC).

In the context of the RBI’s latest projections, CPI inflation is estimated to average around 5.25 percent in H2FY23, as against the earlier expectation of around 4 percent. Given that monetary policy typically takes effect with a lag, one feels that the H2FY23 inflation expectation is of critical importance. Indeed, if the inflation projection of 5.25 percent for H2FY23 eventually needs to be revised upwards, rather than downwards, going forward, it might lead the central bank to raise the repo rate earlier than what was previously expected.

Key concern of late had been the likely pressure from the global central bank policy cycle on Indian policy rate cycle. While pressure for not falling completely out of sync with the global cycle for an emerging market central bank cannot be denied, one needs to recognise that the deviation in case of inflation and GDP growth from their respective trend-lines in the US is much more pronounced than in India at the moment. Thus, while the RBI has clearly stepped up its efforts and preparedness of further normalisation of policy, the action on the repo rate front can stay nuanced for some more time.

To continue stimulating the flow of credit into the economy, the RBI’s announcements such as extending the timeline for which risk weights on individual housing loans will remain rationalised (up to March 31, 2023) is a welcome step. This should help demand for housing, especially affordable housing. The RBI’s announcement will help lenders channel more credit flow into this sector in the current financial year.

The April 8 commentary on SLR holding in the Held To Maturity (HTM) category is also very significant for the fixed income markets. The limit and timeframe for banks to hold SLR bonds under HTM have both been enhanced by the RBI, along with a detailed long-term roadmap for normalisation. This should act as an enabler to help the market absorb the likely high quantum of government papers and support the latter’s borrowing programme, while containing the upside pressure on the overall interest rate spectrum, and, thereby, partly mitigating crowding out effects on commercial credit.

In the policy communication the RBI came out much more concerned about inflation, despite a sizeable lowering of growth forecasts. It seems that managing inflation has moved materially in their priority ranking between the February and April MPC meetings. While the headline policy stance still remains ‘accommodative’ with unanimous voting, the MPC has clearly stepped up its preparedness to combat inflation and, to start with, accelerate withdrawal of crisis time accommodation.

Siddhartha Sanyal is Chief Economist & Head of Research, Bandhan Bank. Views are personal, and do not represent the stand of this publication.