Monetary policy will continue to have role in supporting fiscal stimulus
The FY22 Budget has definitively shifted the fulcrum of recovery away from the earlier dominant monetary stimulus, manifest in the ostensible Survive, Revive and Thrive strategy, to fiscal policy. Yet monetary policy will play not just a supporting, but an equal, flanking role in reinforcing the government’s expenditure boost inter alia by anchoring interest rates. This will need to be accompanied by managing a gradual, calibrated normalisation of the accommodative stance in order to reduce potential financial stability risks.
The MPC will keep the policy repo rate on hold, unanimously, despite the prospect of a drop in CPI inflation to 5 per cent in Q4 and then likely to average 4.5 per cent in FY22. The accommodative stance will be maintained.
Not only are there continuing risks from higher global inflation (metals consumption ex-china was very strong in Q4 ’20), a quicker and seemingly more broad-based recovery in India might push inflation. Consensus forecasts on crude in 2021 remain in the $60/ barrel range. The effects of the higher government spending envisaged in Q4 of FY21 also need to be monitored.
Having said this, initial readings of the set of leading and concurrent indicators we track suggest a slight tick down of economic activity in January. Sustaining the recovery deep into FY22, and then pushing up India’s potential growth upwards of 7 per cent will not be easy.
Increasing credit, more broadly the total flow of funds, to borrowers will need to complement the fiscal measures to sustain the recovery momentum. We had expected the Budget to have expanded the scope of credit guarantees following the template of the fairly successful ECLGS model for MSMES, particularly for farm loans. While this did not happen, details of operationalising the new institutions and mechanisms which have been proposed will need to be monitored, to gauge their likely impact on credit flows in the medium term. As the forbearance measures are gradually rolled back, the resulting stress on loan portfolios will also be a decision factor.
Even if inflation stabilises at around 4.5 per cent, there is virtually no space for any cut in the repo rate. As recovery progresses, policy and short-term rates will need to be taken up into positive real territory, reversing the deep negative real rates we have had for most of 2020.
The US Fed is likely to start tapering sometime later this year, and will contribute to increasing global volatility with spillovers to EMS, although probably weaker than the 2013 episode. Hence, policy statement and communication will be about keeping markets stable while the normalisation process is taken forward in baby steps.
Although the time for initiating normalisation is still distant, markets will gradually need to be prepared for tightening financial conditions. Yet, we expect the autonomous drivers of liquidity to add to the current surplus in FY22. Hence, the design of the normalisation process, including the timing of the expected hikes in the reverse repo accompanying liquidity management, will be crucial.
Forward guidance plus signaling through OMOS, twists, auction yield cut-offs, variable rate reverse repo auctions, forex market interventions, etc, will be part of communication strategy.