The RBI’s sanguine inflation bet

At the conclusion of its last bi-monthly meeting in FY2021-22, the Monetary Policy Committee of the Reserve Bank of India kept the policy repo rate unchanged at 4 per cent. As previously, while this decision was unanimous, continuance of the accommodative stance of the monetary policy entailed a dissent vote.

A section of the market participants and analysts expected that the MPC will change the stance from ‘accommodative’ to ‘neutral’.  And there were a few others, who expected that it will normalise the policy corridor back to 50 basis points by raising the reverse repo rate from 3.35 per cent to 3.50 per cent. Nevertheless, the bond market extended a smile to the policy announcements with the yield on the benchmark 10-year government security falling by 5 basis points. For the present, the bearish tendency that enveloped the bond market in the wake of the Union Budget last week, on the back of record increases in both gross and net market borrowings of the Centre in FY2022-23, stands reversed.   

Fighting shy of normalisation?

The rationale behind the expectations, as above, has been that in the recent weeks, variable rate reverse repo (VRRR) auction for 2 days to 14 days, which is now the main instrument for liquidity absorption by the RBI, was done at much higher rates - close to 4 per cent. In fact, the weighted average rate – which the RBI now terms as the effective reverse repo rate (ERRR) - for the 2-day VRRR auction on February 9, 2022 was 3.98 per cent.  ERRR increased from 3.37 per cent as at end-August 2021 to 3.87 percent as on February 4, 2022. This coupled with the fact that the overnight MIBOR benchmark which is currently at around 3.50 per cent has been slowly creeping up since the middle of 2021 clearly indicating that keeping the policy reverse repo rate unchanged at 3.35 per cent is not consistent with the underlying liquidity condition. Buoyant credit growth, on one hand and lower deposit growth, on the other, in recent months lends support to this observation.  

It is not clear why the MPC has avoided normalisation of the policy corridor by raising the reverse repo rate. Two considerations might have weighed with the MPC: One, any rate action could push up yields on government securities which will impact banks adversely when they close their books on March 31. Two, the banks’ ability to absorb the very large supply of government securities in FY2022-23 at the current level of their yields will be constrained, particularly in the light of the RBI’s plan to align their valuation norms in sync with the global standards and practices in this regard. Consequently, the RBI will be required to step in to make a success of the government’s borrowing programme. As a fallout of this, the RBI will also be required to soak, by way of reverse repo of overnight and other tenors, the significant primary liquidity that will flow to the banks as a result. If this scenario indeed turns out to be the case, then the RBI will prove to be a really slow-turning ship when it comes to liquidity normalisation and/or an adjustment of the policy corridor.                       

Growth and inflation outlook

Projected growth for FY2022-23 has been pegged at 7.8 per cent, with a good bit of quarter-to-quarter unevenness. In fact, growth in the last quarter is projected at 4.5 per cent as against 17.2 per cent in the first quarter.

As regards inflation, the MPC expects a good deal of moderation in FY2022-23, with the headline CPI inflation decreasing to 4.5 per cent from 5.3 per cent in FY2021-22. In the MPC’s assessment, while there are significant downside risks to the growth outlook, risks to the inflation outlook are broadly balanced.

The MPC’s favourable inflation outlook rests on three broad pillars: One, private consumption demand is still weak. Two, supply-side issues, if any, will be addressed adequately and on time by the government. Three, although core inflation remains elevated, yet demand-pull pressures are still muted and pricing power of manufacturing and services firms is not likely to be strong. In other words, the pass-through impact of prevailing very high WPI inflation to CPI inflation remains limited. The only wild card here is crude price.

The reasons why private consumption is still lagging and has yet to surpass its pre-pandemic level are varied and complex. It is likely that in the period following the outbreak of the pandemic in early 2020, private spending patterns have undergone some long-term shifts, principally on account of increased adoption of technology in the workplaces as well as in the day-to-day lives of households, especially in the urban areas. The exact features and characteristics of this phenomenon are not fully known yet. But it is doubtful if continuation of the status quo in the monetary policy will in any manner support private consumption.

As regards regulatory measures, the decision to increase the NACH (National Automated Clearing House) mandate limit for settlement of TReDS transactions from the current Rs. 1 crore to Rs. 3 crore is a welcome step. But it’s time both the RBI and the government take a hard look at the causes of low growth in TReDS volumes in all the three platforms that exist for this purpose now.

The RBI has attempted to downplay the risks of a further rise in commodity prices and the imminence of monetary tightening in the US

Reluctance of most central public sector enterprises (CPSE) to facilitate discounting of invoices drawn on them by their supplier MSME units is the core issue. Interestingly, although following the government’s diktat of 2017 in this regard, a majority of the CPSEs have registered themselves with TReDS platforms, the actual volume of transactions attributable to them has remained very low till now. Unlike their private sector counterparts, CPSEs take excessive time in approving invoices, thereby making it impossible for the invoices to be subjected to any discounting mechanism. 

Permission for banks to deal in Foreign Currency Settled Overnight Indexed Swaps (FCS-OIS) with non-residents is also a welcome step. FCS-OIS has been in existence in a few offshore locations for quite some time now. Making possible a formal link between OIS traded in offshore and onshore markets will benefit all the users of this rupee interest rate derivative.

By all indications, this ‘no change’ policy draws its justification from a favourable inflation outlook. It also seeks to signal that the RBI would continue to stand ready to provide support in case any of the downside risks to growth materialise in FY2022-23. However, in doing so, it has attempted to downplay the risks of a further rise in commodity prices and the imminence of monetary tightening in the US. A clearer picture on all these issues will emerge when the MPC meets next in April.   

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