Baby steps for RBI is not as easy as it seems

Recall that the RBI took similar baby steps a decade ago, rolling back measures taken to address the impact of the 2008 financial crisis. Later the then Governor D. Subbarao later said that the central bank probably should have acted a little sooner. The position of Governor Shaktikanta Das is more difficult than that of his predecessor.

On Friday, the central bank announced that it is ending its G-Sec Acquisition Program (G-SAP), through which it has ₹2 trillion worth of durable liquidity in the first six months of FY22. The first step has been taken to prevent liquidity injection. Economists believe that this will be followed by a hike in the reverse repo rate in the December meeting of the Monetary Policy Committee (MPC) and finally a hike in the repo rate can be expected only in FY23.

“The move by G-SAP and VRRR should lead to a steady increase in the effective rates and is likely to be followed by a hike in the reverse repo rate (3.35% to 3.75%) in the December and February meetings. Thereafter, we expect a change in stance around the February/April meeting after the adjustment will lead to a shift from neutral. In our view, the repo rate hike will happen only in 2HFY22,” HSBC Securities and Capital Markets (India) Pvt Ltd wrote in a note.

In short, it will take more than a year for the RBI to completely phase out its liberal monetary policy. Some economists have warned that this deadline could extend further. While it is easy to avoid fresh injections of liquidity, the biggest challenge will be to neutralize the huge surplus liquidity.

State Bank of India chief economist Soumya Kanti Ghosh points out that the central bank’s unwinding of $23 billion of forward dollars has resulted in liquidity injections. Furthermore, the current surplus is an unprecedented ₹9-10 trillion.

“In view of all this, RBI’s efforts to bring down the reverse repo ₹3-4 lakh crore in December as the governor has told the present ₹8.8 lakh crore will be the most challenging,” Ghosh said in a report.

Fortnightly Variable Reverse Repo Rate (VRRR) auctions are strategic absorption instruments and not permanent deactivation. Ghosh expects that the Reserve Bank of India will not be able to hike the reverse repo rate in December.

To be fair, the RBI has made a strong case for a gradual approach in unwinding. It believes that the growth recovery is still fragile and there is a lot of slowdown in the economy. Demand has not yet reached pre-pandemic levels and capacity utilization is well below historical trends. Credit growth is still slow. There have also been risks to global growth and could have implications for the domestic economy. Rapid closures can disrupt financial markets and impact fund flows to productive sectors. Economists also see merit in a gradual withdrawal given the disruption in the financial markets. But one cannot make an omelet without breaking an egg. Inflation will increase with economic recovery. The RBI is betting that inflationary pressures, both from the supply side and recovery, do not get out of hand.

Could RBI be wrong in this assessment?

Here are the potential risks to RBI’s perceptions. Asset price inflation is already accelerating, as bond yields rise around the world and equity valuations back home. Global commodity prices are not expected to ease as supply constraints may take time to clear.

But perhaps the RBI’s own surveys may see a stern warning on prices. Its consumer confidence survey shows that more Indians expect inflation to rise sharply over the next one year.

True, the domestic inflation expectations for three months ahead and one year ahead are lower in the current round than the previous ones. That said, these expectations are still high.

Inflationary pressures may be temporary but if inflation expectations are not there, the RBI will face a new problem.