The Reserve Bank’s Monetary Policy Committee (MPC) is scheduled to announce the RBI policy resolution on February 10, 2022.
We believe that conditions are primed for RBI to begin normalizing monetary policy as uncertainty related to the durability of growth recovery has reduced. The Omicron-led Covid-19 wave which was one of the factors that kept RBI on pause in December has peaked and states have begun to ease restrictions. The impact on growth is likely to be much lower than the previous Covid-19 waves, with recovery in high-frequency activity indicators such as individual mobility and freight movement in less than a month.
Our business continuity index which had briefly dipped in January 2022, is showing signs of recovery with improvement in individual mobility, freight movement (GST E-way bills and railway freight) and electricity generation. In contrast, recovery from Delta last year took two months and the dip in activity indicators was much steeper. This is also confirmed by PMI for manufacturing and services which had dipped in the contraction during the Delta wave but have remained in the expansion (above 50 reading) during Omicron.
Hence conditions are suitable to begin the normalization of the policy rate corridor, spread-over two policies with a 20bps reverse repo rate hike in February and a 20bps rate hike in April 2022. We don’t expect one-step policy rate corridor normalization with a 40bps reverse repo rate hike in February, as it will generate the expectation that the repo rate hike isn’t far away. That said, if RBI decides to delay the reverse repo rate hike to April then the chances of a one-step 40bps hike are higher.
The reverse repo rate hike does not represent the tightening of monetary policy as the weighted average reverse repo rate (fixed rate and variable rate) has risen to 3.9%. This has been achieved by increasing the size of variable rate reverse repo (VRRR) auctions which currently accounts for 85% of the funds at the reverse repo window. Instead, the reverse repo rate hike will help reduce the volatility in overnight rates which has increased significantly over the last few months.
While a reverse repo rate hike isn’t considered as policy tightening, a repo rate hike is, and its timing will be a function of domestic growth-inflation dynamics. In the December 2021 policy meeting, RBI indicated that until the recovery becomes more broad-based, continued monetary policy support remains vital. Broad-based recovery was defined as one where the private sector (consumption and investment) recovers back to pre-pandemic levels and services recover lost ground.
A key factor that has allowed the RBI space to wait for the broadening of growth impulses is an expectation that Headline CPI inflation will gradually move towards 4%. Upside pressure on inflation is led by fuel and core inflation while food inflation has remained moderate. Supply-side disruptions have resulted in elevated goods inflation while services sector inflation has remained relatively contained, with the pandemic impacting services sector recovery.
This is likely to change as Covid-19 becomes endemic and services sector recovery picks up momentum. The risk to inflation trajectory remaining elevated stems from supply-side disruptions persisting which could keep goods inflation elevated, while services inflation also begins to pick up. Inflation expectations which have also risen is another factor that can add to persistence to inflation, limiting the policy space for RBI to remain accommodative.
Our inflation model currently indicates that Headline CPI inflation is likely to average at 5.8% in Q4FY22 and at 5.3% in H1FY23. We are building-in moderation in Headline CPI inflation in H2FY23, assuming supply-disruptions abate. As long as, inflation is on a moderation path and remains below the 6% upper threshold, monetary policy normalization is expected to be gradual. We expect repo rate hikes from H2 2022 onwards, building-in two hikes in CY2022.
Another aspect of monetary policy normalization will be reducing the substantial surplus liquidity. RBI’s has adopted a gradual approach to liquidity management, using tools such as VRRRs to lock in liquidity for a short period ranging from two days to 28-days. The central bank has avoided permanent liquidity withdrawal (such as OMO sales, etc.), even though core liquidity remains substantial at Rs 10 trillion as of January 2022. The focus has been on allowing the liquidity surplus to reduce naturally via currency leakage and FX outflows. This approach of gradualism towards liquidity management is likely to persist due to the large Central government borrowing program, which has added another layer of complexity.
The planned gross g-sec issuance of Rs 14.3 trillion in FY23 (adjusting for Rs 636 billion of switches done in January 2022), represents the third year of a large government borrowing program. However, unlike the past two years, market appetite this year is likely to be much lower in a rising yield environment. The US Fed is likely to start quantitative tightening which will add upward pressure on UST yields and domestically, we expect RBI’s rate hiking cycle to start. Moreover, the Union Budget did not provide a roadmap for global bond index inclusion, which indicates that actual index inclusion is likely to be some time away.
A possible measure to maintain market appetite could be extending the special dispensation of the enhanced HTM limit of 22% of NDTL by another year. In a recent discussion paper (Review of Prudential Norms for Classification, Valuation and Operations of Investment Portfolio of Commercial Banks, Jan 2022) the RBI has proposed doing away with limits on HTM and replacing it with measures that control the sales out of HTM.
Looking beyond the February meeting continued support will be required for the orderly conduct of the FY23 market borrowing programme. In FY21 and FY22, the RBI had provided its support by purchasing g-secs worth Rs 3.1 trillion and Rs 2.1 trillion respectively. Our calculations show that RBI might need to purchase Rs 4 trillion of g-secs in FY23, to cover the gap between supply and marketability to absorb. To prevent further addition to already substantial surplus liquidity conditions, this could be in the form of liquidity neutral Operation Twists or outright OMO purchases combined with measures to sterilize the liquidity impact.
(Gaura Sen Gupta is an economist with IDFC FIRST Bank with around 13-years of experience in macroeconomic and policy research.)
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