Monetary Policy: RBI Takes Its Own Path Of ‘Least Regrets’
In the run-up to its first meeting since the second Covid-19 wave subsided, the Monetary Policy Committee was widely expected to keep policy settings unchanged as the spotlight advanced to the leadership’s communique, especially around the balance of risks to inflation, which remains elevated, and growth, which remains weak.
For some time now, markets have been looking for the Reserve Bank of India to drop hints of when and how the bank plans to exit its extraordinarily accommodative policy settings. Still, the RBI has time and again said, both through policy meetings and off-cycle interviews, that the timing for any exit is not now. This to us indicates that the RBI is following its own path of ‘least regrets’, a phrase used extensively by the Reserve Bank of New Zealand last year in its policy deliberations.
Like the RBNZ, we think that the RBI too has decided to adopt an approach that in retrospect will be cause for the least amount of regret when it looks into the rear-view mirror, amid the evolving trade-off between reviving growth and managing inflation. This dynamic has manifested itself in the RBI providing more accommodation, and for a longer time, as it has clearly stated that unless and until growth is put on a path of sustainable recovery, policy conditions cannot change, lest the bank should regret dialing back on support pre-emptively.
Reading The Signals
The MPC on Aug. 6 voted unanimously to keep all key policy rates unchanged and broadly maintained its stance of continuing with supportive monetary conditions until growth is on a sustained recovery path with narrow tail risks. A mild hawkish surprise came as an external member, Jayanth Varma, expressed reservations about maintaining the accommodative stance. However, it is unclear from the monetary policy statement whether he wanted the stance to be changed to neutral. But to a large extent, we think the divergence may not be construed as a shift in the MPC’s bias towards giving growth primacy over inflation, under current circumstances.
Today’s decision and press conference also echoed Governor Shaktikanta Das’ recent efforts to prevent market pricing of an early normalisation. Statements like: “It is not like any other year, when inflation goes up, you start tightening the monetary policy” and “pre-emptive monetary step will kill hesitant recovery” reflect that the RBI is going to start an exit from crisis time settings much later, and only when it is sure it is time to do so.
We think the bank has little to gain by providing signals about its normalisation path at this latest meeting.
The RBI retained its growth forecast for FY21-22 at 9.5%, flagging the hesitant and weak recovery. The bank forecasts imply that the output gap will remain negative for some time. At the same time, having faced consistent upside surprises to its inflation forecast, the bank raised its price projections materially. It now expects retail inflation to average 5.7% YoY in FY22 and remain sticky, above 5% over the forecast horizon. Governor Das reiterated the position that the current bout of price pressures is imported and likely transitory, with the statement de-emphasising logistical difficulties as a risk to the price trajectory.
No Hasty Moves
RBI Deputy Governor Patra later stated that the aim of flexible inflation targeting now is to bring inflation down from the pandemic high “not immediately, but over a period of time”, likely to temper concerns that the RBI is letting prices climb rather than adhering to its target. Taken together, the forecasts emphasise that the bank is keeping growth center stage for now. An elevated inflation path suggests that once the growth recovery is sustainably underway, the bank’s hesitance to normalise monetary conditions may fade.
The RBI will signal an exit only when ready, ensuring that the gap between communicating its intention and triggering the exit is small. The governor noted on Friday that the bank will return to inflation targeting “as soon as prospects of sustained growth are assured”, underpinning our view that once the RBI is confident about growth revival, the bank will start to hike interest rates, and unwind the extraordinary support provided during the pandemic in close sequence. Indeed, such a policy would also be optimal; research has shown that faster changes in policy rates are welfare maximising for India's economy.
Still, economic activity recovering to pre-second wave levels is increasing the RBI’s degrees of freedom in framing policy. While a hike does not seem imminent, the RBI has initiated steps to drain excess liquidity provided during the pandemic. Though the CRR-related liquidity removal is being replenished by G-SAP purchases, the RBI has been allowing a passive reduction of liquidity through the natural drains of currency in circulation and capital flows.
The central bank, while assuring markets of continued liquidity support, today announced that it will scale up its variable reverse repo rate auctions. The governor believes the market does not view this step as a reversal of accommodative policy, but a measure needed to ensure that liquidity can be better managed, adding that banks have avenues to park their excess liquidity with the RBI for a slightly longer tenor if needed.
Keep A Close Eye On The Next One
While this August policy review did not bring any material surprises, the October policy review gains a lot of significance as there should by then be some concrete evidence on the durability and strength of the growth recovery as well as the pace of vaccination. Time will tell…
Rahul Bajoria is Chief India Economist, and Shreya Sodhani is Economist, at Barclays.
The views expressed here are those of the authors, and do not necessarily represent the views of BloombergQuint or its editorial team.