Friday, December 1, 2023

RBI policy preview: Pause on rates and liquidity


Since March 2020, RBI has reduced repo rates to a record low of 4% through two rate cuts of 75 bps in March 2020 and 40 bps in May 2020. Since then, the RBI has refrained from taking any action on interest rates. With the October RBI policy set to be announced this on October 8, what are going to be the steps?

The build-up to every RBI policy is interesting, the August RBI policy was all about how the apex bank will deal with the build-up in surplus liquidity and the October RBI policy is about whether conditions are primed for policy normalization to begin.

There are three key differences in the conditions surrounding the August RBI policy and October RBI policy, which will have a bearing on RBI’s reaction function:

  1. Growth conditions have improved and the risk of third wave appears to be lower
  2. Inflation trajectory has improved but external risks have increased
  3. Global monetary policy backdrop has changed with the US Fed turning more hawkish

Starting with growth, conditions have steadily improved as lockdown restrictions have been eased and the pace of vaccination has accelerated. Several indicators are painting a picture of strong growth revivals such as tax collections, listed company performance and PMI for manufacturing and services in the expansion zone.

These indicators are representative of the formal sector which was able to remain functional during the lockdowns and benefited from easy financial conditions. A large part of the pain is in the informal sector, which is not being captured due to the lack of data. However, its impact is likely to be felt in terms of future growth recovery. This is because the majority of the workforce is employed in the informal sector (85% of nonfarm employment as per ILO).

Another issue distorting the growth picture is base-effects caused by the sharp decline last year. To avoid this, we look at monthly indicators over a two-year horizon (2021 v/s 2019). On this metric, around 36% of the indicators remain below their pre-pandemic levels (FY20) as of August 2021. Hence while the current conditions don’t warrant an emergency level of accommodation, they also don’t support withdrawal of policy support.

Coming to inflation, conditions have improved with headline CPI inflation softening to 5.3% in August 2021 from a post-second Covid-19 wave high of 6.3% in May 2021. The headline hides two divergent trends – reducing food inflation and elevated core inflation. The latter has been driven by elevated fuel cost and disruption in services due to lockdown restrictions.

The surge in cost-push pressures (fuel and metal prices) is seeping into manufactured product prices as reflected by non-food manufacturing WPI inflation averaging at 10.3% in FYTD22 (Apr-Aug). The pandemic has likely changed the pricing power of producers with larger firms gaining market share. Hence despite the presence of excess capacity, producers are gradually passing on higher cost pressures.

The cost-push pressures will keep core CPI inflation elevated but Headline CPI inflation is expected to be more moderate.

The cost-push pressures will keep core CPI inflation elevated but Headline CPI inflation is expected to be more moderate. This is mainly due to supportive base effects as well as moderation in food inflation. For now, we don’t see indications for generalized price pressures with 19% of the index accounting for 50% of overall inflation. This however could change with global supply chain issues persisting for longer, increasing the risk of imported inflation for India.

At the current juncture, we expect headline CPI inflation to moderate to 4.7% in Q3FY22, undershooting RBI’s estimate of 5.3%. Subsequently, CPI inflation is expected to rise to 5.8% in Q4FY22 as demand conditions improve and a fuller pass-through of input cost pressures to consumers takes place.

Will current inflation conditions force RBI’s hand? We don’t think so, with the RBI favouring a targeted glide path of gradual disinflation. This is because the reduction in inflation is associated with output loss which is captured by the concept of sacrifice ratio. The RBI estimates that a 1% reduction in inflation will require a 1.5-2% reduction in growth. Our FY22 inflation estimate indicates that India remains on the gradual disinflation glide path with CPI averaging at 5.3% v/s 6.2% in FY21. In fact, our estimate undershoots RBI’s estimate of 5.7% and therefore doesn’t support the need for a tightening RBI policy in October.

Lastly, global monetary policy focus is turning towards policy normalization with Fed sounding more hawkish and inflation in the US looking more persistent. This raises the risk of capital outflows from EMs in case Fed policy normalization is faster than expected. Moreover, elevated crude oil prices and rumblings in China’s real estate market indicate that global conditions may be more volatile as policymakers shift gears from pre-pandemic levels to post-pandemic levels.

RBI would like to retain flexibility on the liquidity front to deal with the ebbs and flows of global flows.

Under such conditions, we expect RBI would like to retain flexibility on the liquidity front to deal with the ebbs and flows of global flows. Hence the first policy step will be refraining from infusing additional liquidity given the build-up in surplus liquidity conditions and not the withdrawal of liquidity. This will result in G-SAPs getting replaced with liquidity neutral Operational Twists and RBI using its forward book to sterilize FX interventions.

Hence, we expect the October RBI policy to be a strategic pause on both rates and liquidity. Strategic because the aim of the RBI policy will be to maintain maximum flexibility to respond to dynamic domestic and global conditions.

Also Read: Indian monsoon 2021: All well that ends well

(Gaura Sen Gupta is an economist with IDFC FIRST Bank with around 13-years of experience in macroeconomic and policy research.)

(Disclaimer: The views expressed in the article above are those of the author’s and do not necessarily represent or reflect the views of Unless otherwise noted, the author is writing in his/her personal capacity. They are not intended and should not be thought to represent official ideas, attitudes, or policies of any agency or institution.)


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