RBI Policy: First Steps Taken Towards Normalisation, Mapping The Next
The monetary policy review on Oct. 8 brought yet another unanimous vote by the MPC to keep policy rates unchanged for the eighth consecutive time. The MPC also maintained its accommodative stance with a 5-1 vote, as was the case in the August policy review.
The timing of the policy review was important. It came after explicit guidance from the U.S. Federal Reserve about the start of tapering in 2021, more rate hikes from emerging market central banks, and a significant rise in commodity prices.
Against this setting, the MPC delivered a balanced policy, one which continues to support growth with calibrated steps to start the process of monetary policy normalization as pandemic-related disruptions abate. We think there are three important takeaways from the policy review.
First, on growth, the RBI highlighted that there are early signs of recovery broadening to all sectors, as indicated by high-frequency growth data and rapid increase in the pace of vaccination. The revival of the contact-intensive services sector is slowly gaining momentum, as illustrated by the uptick in services PMI, which remained in expansionary territory for the second consecutive month. As such, the RBI retained its growth projection at 9.5% YoY for FY22. We concur with the RBI’s view yet believe that growth could be higher than the RBI’s estimate. In our view, pent-up demand, strength in exports, increase in public capex, and increase in the pace of vaccination — which will help in a full-fledged consumption recovery — will drive growth higher in the near-term. Indeed, the recovery in GDP until now has been driven by capex and exports, with consumption lagging. We believe that nearly all of India’s adult population will be fully vaccinated by early next year, which should drive a broad-based consumption recovery.
As such, in the near term, we expect GDP growth to turn positive on a two-year CAGR basis from quarter-ended September and build on that recovery in the subsequent quarters.
We also remain optimistic on the capex recovery, helped by improving demand conditions, increase in capacity utilisation rates, and supportive policy measures — such as lower corporate tax rates, implementation of production-linked incentive schemes, national infrastructure pipeline, etc. — helping to crowd in private capex in the next 12-15 months
Second, on the inflation front, the MPC lowered its headline CPI projection to 5.3% for FY22 from 5.7%, in line with our expectations. This reflects favourable base effect and robust summer crop sowing, with risks broadly balanced even as core CPI (CPI ex-food fuel) is expected to remain sticky. We also estimate inflation at 5.3% in FY22, with near-term inflation readings trending below the 5% mark, but we remain cautious about upside risks from surging commodity prices. Indeed, global commodity prices have spiked in the last few days with oil prices up 13.7% MoM and coal prices up 15% MoM. Moreover, some FMCG firms have recently hiked prices raw material costs remain elevated. As such, we are concerned about potential cost-push inflation seeping into retail prices.
Third, the RBI addressed the excess liquidity situation approaching the inflection point of monetary policy reset. From a liquidity perspective, the RBI decided to withdraw surplus liquidity in a "gradual, calibrated and non-disruptive" manner, commensurate with the evolving macroeconomic conditions, to ensure adequate financial stability. As such, it decided against conducting the third tranche of the G-Sec Acquisition Programme. However, it asserted that it could conduct Operation Twists and Open Market Operations and even reintroduce G-SAP if warranted by the emerging liquidity conditions. Further, the RBI also announced increasing the quantum absorbed under the 14-day Variable Reverse Repo Rate auctions to Rs 6 lakh crore by the first week of December (from the current Rs 4 lakh crore). In addition, it may also attempt to supplement 14-day VRRR, its primary instrument to rebalance liquidity, with the 28-day VRRR in a phased manner. These measures were in line with our expectations.
To conclude, the MPC review remained steadfast in its support of growth. At the same time, it took steps to manage excess liquidity in a calibrated manner. Indeed, interbank liquidity surplus has been tracking near all-time highs of $115 billion, with weighted average call rate consistently below the reverse repo rate (the lower end of the policy rate corridor) since May-2020.
Moreover, short-term real rates have been in negative territory since November-2019, and in comparison with other EMs, India’s short-term real rates are the most negative.
At the same time, as we highlighted above, we expect GDP growth to expand on a two-year CAGR basis in quarter-ended September, with quarterly GDP in level terms reaching pre-pandemic levels. In this context, we believe that a reset of the pandemic-related / exceptional monetary policy operations is warranted because growth conditions are fast normalising.
We believe that the next step in policy normalisation would be narrowing of the policy rate corridor through a reverse repo hike (15 basis points) in the December policy review. As such, we expect reverse repo hikes in the December and February reviews, which will help to narrow the corridor back to pre-pandemic levels. In terms of a repo rate hike, we believe that with growth accelerating and recovery getting broad-based, the RBI could take up a repo rate hike in the first quarter of 2022 as well. Further, we reckon that the gradual withdrawal of policy accommodation will be consistent with the recovery in growth and should not be disruptive. The risk to a delayed pace of normalisation will be contingent on evolving growth conditions and management of the Covid-19 situation.
Upasana Chachra is Chief India Economist at Morgan Stanley.
The views expressed here are those of the author, and do not necessarily represent the views of BloombergQuint or its editorial team