MPC status quo has a different sub text

As widely anticipated, the Monetary Policy Committee of the Reserve Bank of India kept the policy repo and reverse repo rates as well as the accommodative stance unchanged for the seventh time in a row at its third bi-monthly meeting this fiscal which ended today.  What was not anticipated at all was that the decision on the continuation of the accommodative stance was not a unanimous one. There was a 5-1 split, which led to a re-assessment of the ‘as long as it takes’ tag attached to the accommodative stance.  Both the short-maturity and 10-year G-Secs lost some value in the immediate aftermath of the policy. The equity market, which seemed somewhat upbeat at the start of the day on the back of the news of abolishment of retrospective tax also traded lower later.

Unprecedented policy challenge

Since the outbreak of the Covid-19 pandemic in March 2020, the RBI has been facing almost intractable policy challenges of having to reconcile and balance several objectives amidst a paradigm shift in the inflation-growth dynamics in this country. By all indications, it is now traversing in an uncharted territory where its straightforward ‘inflation targeting’ framework works, but partially. On the one hand, the country’s growth prospects for 2021-22, though reasonably good, could suffer a serious setback if the fear of a third wave materialises.  A large number of units in the MSME and informal sectors continues to be in different stages of fragility.

The country’s growth prospects for 2021-22, though reasonably good, could suffer a serious setback if the fear of a third wave materialises.

On the other hand, the supply side disruptions and surge in commodity prices continue to pose threats of higher inflation.  The resulting tension in monetary policy-making is obvious and visible too. However, in the midst of all this, one has to contend with a possibility now being faced by all major central banks: if the past is any guide for the future, the current ultra-loose monetary and liquidity stance, which has already caused significant asset-price inflation will have a malign influence on the CPI, if continued indefinitely.  In India, one has witnessed retail inflation prints staying above 6% both during June-November, 2020 and in May and June, 2021. In MPC’s judgment, the recent uptick in CPI is transitory and it expects inflation to ease in the third quarter of 2021-22 with the arrival of the kharif harvest and as supply side measures take effect. It posits that demand-pull pressures remain inert, given the slack in the economy. Hence, revival of growth will continue to be accorded priority. 

The commentaries accompanying the policy announcement have sought to dispel any doubt that may be caused by the split decision and also to make sure that the bond market, especially its G-Sec segment, does not overreact to it. But, to be sure, the market has already taken a cue from the facts that the RBI no longer intends to resist with all its might any movement in 10-year G-Sec yield above 6% and that its emphasis on ‘orderly evolution of the yield curve’ – whatever this may mean - is not as strong and vehement as it was even a few months back. If CPI for July or August moves past 6%, then one is likely to see the 10-year G-Sec yield much above the current level of 6.24%.

Against the backdrop of a slew of G-Sec auctions going wrong in the last few months due to large devolvement as well as cancellations, the decision taken last month to hold auctions for G-Secs up to 14-year maturity on uniform price basis is a pragmatic move that is likely to ensure the success of the government’s borrowing programme for the remainder of the current fiscal, albeit at higher yields. All in all, the RBI is very careful with a view to containing, at least for the present, any expectation or apprehension about policy normalisation any time soon.       

Multiple objectives

The call rate, which was 3.07% on August 5, has moved further away from the LAF corridor 3.35% - 4% again in the last few months, in tandem with a spurt in the amount of liquidity absorption by the RBI through reverse repo, which increased from a daily average of Rs. 5.7 lakh crore in June to Rs. 6.8 lakh crore in July 2021 and further to Rs. 8.5 lakh crore in August 2021 so far. The main reason for this has been liquidity infusion resulting from the RBI’s forex intervention in the spot market, which is not being offset by way of adequate sell-buy swaps, as was the case in 2020-21. The amounts of purchase and sale of forex (in US dollar billion) in the first five months of 2021, the latest period for which data are available, would illustrate this observation:

In the current fiscal so far, the RBI has not engaged in forex sell-buy swaps to the extent it did in 2020-21, with the result that the forward premia have come down from the high levels seen earlier. The surge in excess liquidity has put the RBI in a difficult situation, since it cannot use OMO in G-Sec to absorb any part of it, lest G-Sec yield should rise. The re-introduction of a 14-day variable rate reverse repo in January, 2021 was a good and timely step, but the RBI’s success in being able to mop up Rs. 2 lakh crore subsequently and its announced plan to increase the amount further have given rise to doubts about the indefinite continuation of the accommodative stance. Resorting to forex sell-buy swaps in a big way could push forward premia to unsustainable levels again. Not intervening in the forex market in the face of strong inflows is also not an option, since appreciation of the rupee could perilously diminish the modest currency valuation reserve it is left with after the profit transfer to the government for 2020-21. Needless to say, it’s going to be a tight rope walk for the RBI in the days to come.               

Going forward, the RBI needs to provide clarity on how it intends to bring down the current excess liquidity within a time frame. The short end of the yield curve is now out of sync with the policy rates and, hence, the current fairly steep slope of the yield curve can send wrong inflation expectation signals. As is well-known, the yield curve is also a pivot for financial stability.       

(The writer is a former central banker and a consultant to the IMF)