The Monetary Policy Committee hiked rates exactly as expected, but RBI's bark was worse than what many in the market were prepared for. There were many signs that the central bank is more eager to remove excess liquidity sooner than what it had led the markets to believe earlier, probably because it expects inflation to be stickier. As a result, post policy, quite a few economists have moved up their peak rate expectations.
SBI's Soumyo Ghosh has upped his peak repo rate forecast to 5.5-5.75% from the earlier 5.25-5.5%. Standard Chartered's Anubhuti Sahay has upped her peak rate to 6% from 5.75% earlier. A few expect the peak rate to come earlier, as early as December. Also, across banks and brokerages, the expectation in the August policy has moved to a 50 bps hike from 25-35 bps earlier.
So what are the signs of hawkishness:
1. Firstly, the Central Bank has raised its inflation forecast for the current year to 6.7% from 5.7% earlier. Many economists and market participants were expecting the inflation forecast to be raised to 6.5%, at worst. (Granted that several economists were already forecasting 7%-plus inflation, but that wasn't the majority view)
2. More importantly, the RBI expects CPI to average at 7.5% in the April-June quarter. This is higher than what economists expected, as JP Morgan's Sajjid Chinoy admits. The RBI usually has a nearly accurate idea of inflation by the end of the month. Hence, many economists now guess that the May inflation reading may come closer to 7.5% versus around 7% that the street was expecting.
3.Thirdly, the MPC also dropped the words "remains accommodative" and straightaway said it is "focussed on withdrawal of liquidity so as to bring inflation closer to target". Although semantically the change is minor, the new wording imparts greater weight to the removal of accommodation.
4. Fourthly, the governor in his speech specifically affirmed a "commitment to move towards normal monetary conditions in a calibrated manner". When asked what he meant by normal monetary condition, he replied, and I quote, "a normal condition would primarily mean when the overnight money market rates are in line with the policy Repo Rate". This means RBI is clearly focussed on draining liquidity to the point of creating deficit liquidity conditions. While it can technically do so even today by conducting more variable rate reverse repo auctions, this is perhaps the first clear admission of wanting to return to a deficit liquidity regime.
Bankers like B Prasanna of ICICI told CNBCTV18 they indeed expect deficit liquidity by the end of this year. Considering that excess banking liquidity is already down to Rs 3.5 trillion, even the normal increase in currency in circulation will suffice to bring down liquidity to zero or negative.
5. Fifth, the governor has so far admitted that liquidity would be withdrawn over a multi-year period. Today he said, the multi-year period began last year, thus creating a suspicion that his "multi-year" period could end this year itself.
6. There was also a distinct refusal to even hint at buying bonds to help the government borrowing program sail. When asked how he would help the borrowing program, the governor elaborated how the RBI has more ammunition to do "operation twists (whereby RBI sells short tenor bonds and buys long tenor bonds thus creating demand for long bonds). With regard to operation twist, we have greater leverage because we have enough securities, " he said. "Because of introduction of SDF, naturally the securities which are available to us which in a previous context, if there was a reverse repo we'd have to give securities; so today we have enough securities to undertake operation twist," he explained. Such a detailed answer on operation twist, gave a distinct impression RBI is in no mood to buy bonds via OMOs (open market operations).
So what happens if liquidity goes into deficit. It means that instead of banks pushing their excess cash to RBI's deposit facility, they will queue up in front of RBI's repo window to borrow. The psyche of a banker faced with the need to borrow from RBI is to first raise deposit rates. This, in turn, means lending rates, too, will be transmitted faster. Some may argue that since banks have pegged many loans to external benchmarks like the repo rate, lending rates will go up even if deposit rates don't. But this is only partly true. When faced with excess liquidity, banks drag their feet to raise rates.
But when liquidity is scarce, the rate hikes come faster.
Let us also note that credit is picking up fast and is now close to 12% versus 8%, just 8 months ago. Also, the governor pointed out that capacity utilisation in the economy has jumped to 74.5% from 72% last quarter. Closer to 80% capacity utilization, companies usually start preparing for capex, as less than 20% excess capacity is considered as good as zero. The merchandise trade deficit and the current account deficit widening with each passing month are also signs of capacity glut diminishing fast.
In addition, Citibank's economist Samiran Chakrabarty has been pointing out to sharp rise in urban wages and hence the likelihood of an incipient wage-price spiral.
In short, if RBI were to reach zero or deficit liquidity by end of 2022 and this coincides with a sharper pick up in credit and wages, we may be staring at far higher loan rates sometime soon.
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