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RBI, IMF see growth intact, inflation declining. Good time to roll back excess liquidity

The key question is how much could domestic interest rates rise with normalising liquidity in the given growth-inflation settings? The timing is significant for understanding this

October 14, 2021 / 03:02 PM IST

The Reserve Bank of India (RBI), which reviewed its monetary policy last week, and the International Monetary Fund (IMF), in its October update of the World Economic Outlook this week, have kept India’s GDP growth forecast unchanged at 9.5 percent for 2021-22.

For next year (2022-23) too, the IMF has retained its 8.5 percent projection, indicating that from the current standpoint it sees recovery enduring through the period. The broader global context is the slight downward revision to world economic growth that is now projected 10 basis points less at 5.9 percent in 2021, followed by an unchanged 4.9 percent growth next year.

The IMF-RBI growth outlook match may reinforce the recovery optimism that has been gaining ground in India of late.

The correspondence extends to the inflation outlook, albeit with differing projections, but similar directional incline, i.e., downwards. The RBI reduced its annual inflation forecast by a steep 40 basis points to 5.3 percent, and foresees the decline maintained in 2022-23: Q1 (5.2 percent), while the IMF projects a respective 5.6 percent and 4.9 percent average change in consumer prices this year, and the next.

While not interpreting the match in growth-inflation outlooks beyond these observations, the RBI’s subtle signal of normalisation on October 8 is well located in this context. The central bank announced a halt to its Government Securities Acquisition Programme (GSAP) or fresh liquidity infusion, reassuring at the same time that the stop did not represent a steep liquidity reduction. A set of changes and additions were also introduced to manage liquidity with increased discretion in the roadmap.

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These are, an extra Rs 500 billion of 14-day variable rate reverse repo (VRRR) auctions every fortnight to reach Rs 6 trillion by the first week of December (currently it is at Rs 4 trillion), the introduction of 28-day VRRR auctions, and the continuation of ‘twist’ as well as open market operations to ensure a gradual, and non-disruptive navigation to the ‘shore’ that the RBI Governor said was “visible”.

Other than these, the central bank’s monetary policy settings remain unchanged. It continues with the accommodative stance for as long as necessary to revive, and sustain growth on a durable basis, and to mitigate the economic impact of COVID-19, while ensuring that inflation remains within target.

The move to start repatriating excess liquidity — in the Rs 12-13 trillion region, no less — is a departure from the hope expressed by Deputy Governor Michael D Patra less than a month ago, i.e., that a natural reduction in the liquidity adjustment facility (LAF) surpluses happens through recovery in credit demand as banks begin to lend. That ideal situation has not come about. Or the central bank isn’t waiting for that.

The prompts could be several, and are open to interpretation. Perhaps a growing unease of the RBI that letting monumental surplus funds persist without credit taking off was getting riskier by the day as recovery gained ground; uncertainty that inflation will steadily return to target in two years, especially in the light of continued oil-price increases, and stubborn fuel levies.

Or an improved cash position of the government indicating it was time to move on —it’s possible to manage sovereign borrowing costs at bond auctions with yields hardening ahead.

External developments are yet another probable reason: global anxieties over inflation escalated in the weeks leading up to the review even as beliefs about its transitoriness remain intact; however, fears over rising natural gas, other energy prices have fanned the spectre of broader price increases, and bond yields have risen across the advanced economies.

The bigger, broader question is how much could domestic interest rates rise with commencement of normalisation given the growth-inflation settings? The timing is significant for understanding this.

The RBI has decided to end the GSAP at a time when inflation has come down so the liquidity impact upon the bond yields will become visible cleanly, and quickly. How much is the contribution of excess liquidity, and how much is the contribution of inflation to the yields is what the central bank would like to see. The timing was most appropriate to observe the exact impact of excess liquidity upon interest rates. Headline inflation, as we know, trended down successively in July-August (and in September, subsequent to the review); in the months ahead, it is favoured by the previous year’s base. The RBI expects annual inflation at 5.3 percent against 5.7 percent in August; the third-quarter expectation is now 4.5 percent versus 5.3 percent before.

The outcome should be known very quickly. Patra elaborated in the post-policy call that the VRRR auctions would aid ‘price discovery’, i.e., a market-determined reverse repo rate for sucking out planned surplus amounts. Interest rates are likely to rise much faster if yields are more sensitive to liquidity; if that wasn’t repressing the yields, the difference may not be that much. It is likely the central bank believes the contribution of excess liquidity in keeping down yields is considerable.

Markets have their expectations too — their brimming growth optimism could cloud or exaggerate the liquidity impact. However, with the array of offsets the RBI can use at will to fine-tune ‘an orderly evolution of the yield curve’, the smooth sail in forthcoming times will be interesting to watch.

Renu Kohli is a New Delhi based macroeconomist.

Views are personal and do not represent the stand of this publication.
Renu Kohli is a New Delhi-based macroeconomist. Views are personal.

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