RBI policy preview: Status quo on rates; focus on liquidity management

RBI policy preview: Status quo on rates; focus on liquidity management

What would be there in the August RBI policy? How the apex bank will try to outline the economy?

In the run-up to the August RBI policy, there has been a lot of focus on the difficult policy choices facing the MPC. On one hand, the virulent second Covid-19 wave has effectively delayed the growth recovery by one quarter. On the other hand, CPI inflation has remained above the 4% target levels for 21 months, despite the presence of significant excess capacity. The surge in inflation has raised questions about whether the growth-inflation trade-off is reducing and whether policy focus should gradually shift from growth towards taming inflation.

In June 2021, the RBI policy had reinforced its forward guidance, stating that an accommodative stance will be maintained as long as necessary to revive and sustain growth on a durable basis. However, conditions since the June policy have changed especially on the inflation front, with CPI inflation breaching RBI’s upper threshold of 6% for two consecutive months. The second Covid-19 wave has ushered in another round of supply-side disruptions which have impacted the contact intensive services sector.

Cost-push pressures from higher fuel and metal prices are getting slowly passed on to manufactured goods prices.

Moreover, cost-push pressures from higher fuel and metal prices are getting slowly passed on to manufactured goods prices. At the current junction, the presence of excess capacity reduces the risk of generalized price pressures. MPC members are likely to view inflation pressures as transitory, with price pressures easing as supply chains normalize. However, the comfort on inflation will be lower with one-year ahead inflation expectation rising to a 4.5-year high in May.

Our inflation model indicates that the CPI trajectory should improve over the next few months, aided by favourable base effects and moderate food inflation. That said, core CPI inflation is expected to remain sticky, averaging at around 6% plus over the remainder of FY22. Elevated core inflation when capacity utilization levels are low, raises the risk that we could see more upward pressure when demand revives.

We expect upward pressures to be more pronounced in Q4FY22 when vaccination coverage improves, supporting consumer sentiment. Moreover, strong global growth implies that elevated fuel and commodity prices are here to stay and hence input cost pressures are likely to persist. We expect RBI policy to revise up its CPI inflation forecast from the current 5.1% in FY22, as Q1 inflation levels have been higher than expected.

On the growth front, recovery has been faster with activity indicators recovering lost ground in three months, compared to 10 months during the first wave last year. This reflects nimbler lockdowns with industries remaining functional to varying degrees and shorter duration of stringent restrictions. To add to this, firms and individuals have become more adept in operating in the new normal.

The improvement in activity levels is indicated by rising in individual mobility, freight movement as well as the lower unemployment rate.  We don’t expect RBI policy to change its FY22 GDP growth estimate of 9.5%, as uncertainty on the growth front persists.

Moreover, the second Covid-19 wave is not yet over with active cases rising over the last few days. Vaccination is the only way to safeguard the recovery and hence policy normalization will only begin once vaccination coverage reaches a certain threshold. This is because as long as vaccination coverage is low, lockdowns remain on the table as a policy tool to deal with a resurgence in Covid-19 cases. This has become a key differentiating factor between DMs and EMs, with the former not having to resort to strict lockdowns due to relatively higher vaccination coverage.

Currently, only 8% of the population is fully vaccinated, with the daily pace of vaccination averaging at 3.9 million in July.

Currently, only 8% of the population is fully vaccinated, with the daily pace of vaccination averaging at 3.9 million in July. We estimate that to fully vaccinate 40% of the population by December 2021, the daily pace of vaccination will need to be increased to 7mn. Hence, we expect the repo rate to remain unchanged in FY22 and are building in reverse repo rate hike only next year in February or April.

The key focus of the August meeting will be on how the RBI views the build-up of liquidity surplus conditions.

The key focus of the August meeting will be on how the RBI policy views the build-up of liquidity surplus conditions. System liquidity has risen to 5.8tn (average in July 2021), while core liquidity has risen to historical highs of Rs 10 trillion. Core liquidity includes government cash balances and indicates that system liquidity is only likely to increase as government expenditure rises. Further factors adding to liquidity surplus will be net T-bill redemptions and G-SAP purchases. RBI will need to maintain the quantum of G-SAP purchases to ensure orderly evolution of the yield curve and keep the funding cost of the government contained.

How RBI policy addresses the excess liquidity build-up will be key, as its accommodative stance has become interlinked with liquidity.

How RBI policy addresses the excess liquidity build-up will be key, as its accommodative stance has become interlinked with liquidity. Hence any change on the liquidity management front could be interpreted by the markets as a stance change. If the RBI were to address the build-up in excess liquidity, it will be via the variable reverse repo auctions. Currently, the auction size has been maintained at Rs 2 trillion and two-week maturity.

The RBI policy could increase the quantum or duration of the reverse repo auctions to address the build-up of surplus liquidity conditions. However, any development on this front is only expected in Q3FY22, when RBI will have a better handle on the recovery and pace of vaccinations.  Communication will play a key role in ensuring liquidity normalization isn’t viewed as a change in stance by the markets. On the rates front, we expect the repo rate to remain unchanged in FY22, and the reverse repo hike is expected only in February or April 2022.

Also Read: Monsoon in India: All eyes on August performance

(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 Autofintechs.com. 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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