A policy hold and a hawkish commentary
We expect that the MPC and RBI will hold key policy rates on Friday. The communication, though, is likely to be hawkish, preparing markets for an inevitable start of formal normalisation, which is now consistent with India’s growth-inflation dynamics.
The RBI is likely to maintain its 9.5% FY22 growth forecast, but there are downside risks, given rising supply-oriented disruptions, and receding but existent Covid flareups. There might be a minor downward revision of the earlier 5.7% CPI inflation forecast, with upside risks.
Fiscal interventions are needed to boost demand and induce durable growth. The role of monetary policy will now largely be smoothening of financial sector volatility arising largely from the imminent normalisation steps of global central banks, and flanking support to maintain financial intermediaries’ stability while incentivising credit growth.
The momentum of growth recovery had slowed in late August continuing into September, although signals are still mixed and the interactions of supply dislocations and demand weakness remain blurred. China developments remain a big concern, with the potential to disrupt the global recovery, with adverse effects on India’s exports. Global prices remain elevated across the board — food, metals, ores, energy, freight and logistics — all of which have the potential to feed into domestic costs and prices. Price pressures can longer be considered “transitory”.
Despite these persistent risks, we think that CPI inflation will broadly follow the glide path projected by the RBI for a gradual decline to around 4 per cent by March 2023 or a little later. We maintain an average 5.2% inflation for FY22, with upside risks from commodities, plus domestic services prices post a vigorous recovery.
Senior RBI management have communicated intent to follow glide paths, not crash landings, in the normalisation process, but the start is imminent. The crucial first steps will be active management of both the quantum and price of the surplus system liquidity, (currently ~8.5 trillion and likely to progressively increase), of the surplus. The quantum has been managed with the additional VRRR offers at different maturities, but a gradual extraction is now warranted. Markets’ interest had shifted to price signaling post the earlier high cut off yield at a 7-day VRRR auction, but the latest cut-off has tempered expectations of a reverse repo rate hike at this review.
As a corollary, the optimum shape of the evolving yield curve will be a decision variable; for best supporting monetary policy objectives, should market interventions focus on the short or the medium/long tenors? India’s sovereign rating outlook upgrade has added an additional variable to the choice. Other than increased FPI interest in government securities, this is likely to facilitate a more rapid inclusion in global bond indices, increasing the potential investor demand pool. The resulting higher foreign currency inflows will permit the RBI to reduce the endogenous liquidity infusion through GSAP and bond purchase programmes.
In summary, while the balance of probability is a policy hold, we think that the RBI should hike the reverse repo rate by a small 10-15 basis points in this review itself. Markets seem to have priced this in, although longer term rates will move up in anticipation of a faster-than-expected increase in the repo rate. Periodic communication of a gradual, calibrated tightening post normalisation will smooth out this volatility.