MPC meet | Policy support rollback needs to be gradual and nuanced

As the economy recovers from the COVID shock, the process of normalising monetary policy support will likely have four steps, potentially somewhat overlapping. The first step is the gradual withdrawal of crisis-time liquidity support – a step that started before October and was in focus during the previous meeting of the monetary policy committee (MPC).

The central bank indicated a road map for absorbing the prevailing large systemic liquidity surplus, along with lowering the quantum of government securities acquisition programme (GSAP), and greater focus on costlier variable rate reverse repos (VRRR). The MPC looks set to continue focusing on gradually absorbing the large systemic liquidity surplus in the coming months, including in the December MPC meeting.

Reverse repo rate

The next step in this process can be restoring the width of the repo and reverse repo rate corridors to the usual 25 basis points (bps), by gradually hiking the latter. The corridor was widened to 65 bps with relatively larger cuts in the reverse repo rate during H1 2020 as an additional knee-jerk support to the banking system during the initial outbreak of COVID. An uptick in the reverse repo rate, as and when it comes, should thus be seen as rolling back of a temporary crisis-time support rather than as a hike in rates.

Also, given the enhanced focus on absorption of excess liquidity, the weighted average call rate (WACR) has started inching higher since September. Overall, we are close to upticks in reverse repo rate – in the first tranche, the uptick can be just a token 15bps. A nuanced uptick in the reverse repo rate may have only modest impact on WACR. While we recognise that the process of normalisation of the reverse repo rate is round the corner, which is partly priced in by financial markets, our baseline expectation is that the process will start in Q1 2022, rather than in December, especially amid the fresh COVID-related uncertainty in recent weeks.

Policy stance, repo rate

Third, the stance of monetary policy needs to shift to “neutral” from the current “accommodative” stance as part of further normalisation. However, as recently as in October, the MPC indicated continuing with  “the  accommodative  stance  as long  as  necessary  to  revive  and  sustain  growth  on  a  “durable  basis”.

Overall, we are close to the change in stance of monetary policy to “neutral”. However, given the emphatic dovish guidance in October, it seems that the MPC may take a tad longer to switch the stance to “neutral”, even though one of the MPC members voted against the “accommodative” stance in October itself.

The RBI commentary will almost certainly indicate the data-dependent nature of policy in the coming months, given better growth prints and continued inflation concerns. Nevertheless, the RBI’s approach in recent months continues to highlight nuanced and data-dependent policy moves, rather than rocking the boat.

The fourth and final stage is hiking the repo rate. The repo rate, the key policy rate for the MPC, currently at 4 percent, is over 200 bps lower than its usual pre-COVID level. The real repo rate – the difference between repo rate and inflation – stays deep into the negative zone since mid-2021. However, hiking the repo rate is unlikely before mid-2022, given persisting negative output gap and prolonged uncertainties.

A nuanced approach amid fresh uncertainties 

Monetary policy is facing fresh challenges of late across the globe. Sharp, unexpected headwinds like major disruptions in supply of industrial raw materials, fuel and energy in a number of leading economies often raises question marks over the pace of near-term economic recovery. Also, commodity price inflation led by COVID-induced supply disruptions seems to be less transitory and spilling over to a wider set of goods and services. Despite the recent, surprisingly strong recent communication of the US Fed as regards stepping up of liquidity withdrawal, one cannot overlook the sharp spike in volatility index (VIX) triggered by Omicron concerns; VIX surged by over 50 percent in less than a fortnight.

India's headline macro numbers including GDP remain strong. MPC’s existing growth forecast of 9.5 percent for 2021-22 appears broadly realistic. However, recovery in the economy remains uneven and shallow. Despite the recent uptick, business and consumer confidence indices remained markedly lower than their pre-COVID levels. Corporate profitability was strong in recent quarters, but may not enjoy strong tailwinds in the coming months amid rising cost pressures. Importantly, while a 9.5 percent GDP growth would mean a strong uptick optically, India is virtually in the middle of a phase of zero growth over a two-year period and the nature of current inflation pressure has typically been beyond the direct immediate influence of monetary policy.

Overall, while withdrawal of crisis-time policy support is set to step up further, it has to be nuanced and gradual, even if erring on the side of caution, rather than a source of surprise in the current stage of nascent and uneven recovery. The MPC has rightly shown abundant caution and patience in the recent past and has indicated repeatedly that they will remain data-dependent. One expects continuation of the same approach in December ensuring avoidance of any material disruption for the economy and financial markets.

Views are personal and do not represent the stand of this publication.