RBI Monetary Policy: Balancing Narrative, Normalisation, Next Steps

We continue to expect a gradual and a shallow rate cycle from the RBI in the coming future, write Shubhada Rao & the QuantEco team

<div class="paragraphs"><p>A weighing scale stands next to sacks of grain at a wholesale grain market in Rewari, Haryana. (Photographer: T. Narayan/Bloomberg)</p></div>
A weighing scale stands next to sacks of grain at a wholesale grain market in Rewari, Haryana. (Photographer: T. Narayan/Bloomberg)

The April 2022 monetary policy outcome saw status quo on the policy repo rate, thereby keeping it unchanged at 4.00% for 23 months, the longest pause since its debut as a monetary policy tool in 2001. While that’s important to keep at the back of the mind, the defining moment for April 2022 policy lies elsewhere.

Seminal Changes

At the outset, it re-establishes the primary policy focus on inflation management. Recall, as growth acquired overwhelming concerns amidst unprecedented shock from the pandemic, inflation deviations vis-à-vis target (as well as band) were ignored for two consecutive years in FY21 and FY22. However, with supply disruptions persisting, unlocking of the economy amidst the receding threat of Covid-19 and rising vaccination coverage could have unanchored inflation expectations, especially in the current backdrop of elevated commodity prices. This is in line with our view of the likelihood of inflation risks getting persistent and pervasive and hence the urgent need for restoring monetary policy focus.

We view this as a critical shift in policy narrative from the whatever it takes accommodative mode to formally laying the groundwork for exiting the pandemic era exceptionally supportive policy framework.

In order to achieve this, the central bank will rely upon the following.

In the immediate term:

  • Restoring the width of the LAF corridor symmetrically to 25 bps on either side of the repo rate. Recall, while the width between the repo rate and MSF rate was maintained at 25 bps through the pandemic period, the width between the repo and reverse repo rate widened to 65 bps since the early part of the pandemic. Reverting to the normal width of the policy corridor would lower volatility in money market rates.

  • The reverse repo rate, the lower bound of the policy corridor, will now get replaced with the Standing Deposit Facility rate. The SDF has been under consideration for quite long and its addition to RBI’s policy toolkit is welcome. Since it is an uncollateralised rate, it expands the central bank’s flexibility in managing surplus liquidity situations. In the current set-up, the SDF has debuted at a level of 3.75%, 25 basis points lower than the policy repo rate.

In the medium term:

  • We expect the central bank to gradually reduce the core liquidity surplus from an estimated level of Rs 8.4 lakh crore in end-FY22 to Rs 2.8-3.5 lakh crore by end-FY23. While this curbing of liquidity surplus would reinforce the objective of inflation management, the weaning off would be spaced out to avoid withdrawal symptoms and to also ensure that financial conditions remain broadly supportive of growth.

What Comes Next?

With RBI having made its policy intent clear, the market focus is now going to shift towards gauging the size and shape of the anticipated rate hike cycle (instituted via change in repo rate) in the backdrop of FY23 inflation forecast getting revised up substantially by 120 basis points to 5.7%. The near 20 bps jump in the 10-year g-sec yield highlights the beginning of the shift in market expectations.

Persistent complacency when shaken can stoke anxiety risks. With the shedding of a dovish demeanour by the central bank, there could be a likelihood of wild swings in market expectations with respect to interest rates.

In this context, we need to acknowledge a few hard truths:

  • The economic scarring from Covid-19 is not just substantial, it is also unequally distributed with the lower end of both the production and consumption spectrum bearing a disproportionately larger burden. While the Indian economy has reverted to its pre-Covid GDP level (in FY22), it will be able to catch up with its pre-Covid trend growth by FY27. This would necessitate monetary policy to continue facilitating growth through various levers at its disposal.

  • Despite the sharp upward revision in inflation projections for FY23, the deviation of inflation vis-à-vis target is not substantial when compared to (i) the broad policy mandate (2-6% range with 4% as the target), and (ii) most developed markets led by the United States. Hence the disinflationary impact of policy normalisation needs to be slow and gradual to minimise the sacrifice ratio at the early stages of recovery.

  • Finally, a monetary policy tightening cycle triggered by a supply-constrained economy will be asymmetric (and less aggressive) to a tightening cycle triggered by a demand constrained economy.

As such, we continue to expect a gradual and a shallow rate cycle from the RBI in the coming future. For FY23, we stick to our call of a cumulative 50 bps hike in the repo rate (assuming crude oil prices stay somewhat lower around $100/barrel levels). This would set the ball rolling on normalisation of the negative real policy rate from an estimated level of -1.5% in FY22 to -1.2% in FY23. A bulk of the adjustment is likely to happen in FY24 with the real policy rate approaching zero and liquidity becoming neutral.

In the interim, to calm down bond market anxiety, RBI’s decision to allow a higher dispensation for banks' HTM portfolio is welcome. This needs to get complimented with timely verbal interventions by the RBI coupled with an assurance of a slow exit (monetary policy normalisation) and ardent upholding of the fiscal consolidation roadmap.

Shubhada Rao is Founder, Vivek Kumar is Economist, Yuvika Singhal is Economist, at QuantEco Research.

The views expressed here are those of the authors and do not necessarily represent the views of BloombergQuint or its editorial team.