Against the backdrop of emerging stagflation pressures, monetary policy around the world stands at an important crossroads – when to begin normalization and at what pace? The issues for the Reserve Bank of India’s Monetary Policy Committee (MPC) will be the same when it meets for October’s policy, and there is no easy answer.
On the development front, growth has been mixed. On the positive side, the MPC is likely to take comfort from the fact that the monthly activity data in a consolidated form is now almost back to pre-Covid levels. Virus and vaccination trends are also indicating less risk of economic disruption from any potential third wave. However, recent developments in China may have transitioned the real economy over global growth and in turn poses some risks to India’s growing exports – an engine of growth that was manifesting well. Furthermore, the breadth of our recovery indicator shows that about 30% of the high-frequency activity variables have not yet come close to their pre-Covid levels, emphasizing the outlook for an uneven recovery requiring policy support.
On the inflation front, the next three months may see a below 5% CPI, creating a very favorable backdrop for monetary policy normalization and the MPC changing its own FY22 inflation forecast (5.7%) to 40. Prompts to reduce by -50 bps. The MPC’s stance of a supply-side transient rise in inflation during May-June has been justified. However, heightened inflation expectations and sticky cores will remain areas of concern, especially when there is a fresh jump in global commodity prices.
Normalization of global supply conditions for various factors and commodities is taking longer than expected and the whiplash effect could keep prices higher despite incomplete demand recovery coupled with uncertain pass-through for Indian inflation. We had highlighted an additional risk of increase in vegetable prices due to unseasonal rains and it would be interesting to see whether RBI incorporates these upside risk possibilities in its forecasts.
Given this macro background, there is some merit in considering the 15bps reverse repo hike for two reasons- one fundamental and one technical. We have to appreciate that the RBI took two extraordinary emergency measures during the first wave – raising the repo and reverse repo rate corridor from the normal 25 bps to 65 bps and bringing the overnight rate closer to the reverse repo rate than the repo rate. that is mandatory. monetary policy framework. The economy still needs policy support, but is no longer in a state of emergency. Therefore, the process of withdrawing the two emergency measures can now be started in a finely calibrated manner.
The technical factor is the avoidable risk of highly volatile short-end rates when the corridor is so wide, and the RBI is conducting very large Variable Rate Reverse Repo (VRRR) auctions every week. Earlier, the VRRR cut-off yields were in the 3.4-3.5% range, but in recent auctions, they have been more advanced and volatile. Having such fluctuating short-term rates may not be a desirable outcome of monetary policy. Gradual narrowing of the corridor will be able to achieve this. Further, as the VRRR cut-off tends to be higher in the middle of the corridor, any small reverse repo hike at this juncture is unlikely to have a significant impact on the overall interest rate structure.
On the management of liquidity volumes, there is a slight possibility that the VRRR program may be expanded to include periods exceeding 14 days. The slightly changed monetary policy stance will also be reflected in the need to moderate the increase in banking system surplus liquidity by lowering the Government Securities Acquisition Program target for the third quarter. ₹50,000 crore or so, and maintain the operational flexibility to conduct open market operations if required. In fact, liquidity concerns may force RBI to neutralize G-SAP liquidity with Operation Twist, especially at times of large capital inflows.
However, the MPC must distinguish between these “operational” changes and the main thrust of monetary policy. Highlighting the soft and uneven recovery and emerging global growth risks, the MPC may reiterate its bias to support growth through an extended period. liberal monetary policy. Communicating this subtle distinction between normalizing “operations” versus maintaining a policy stance can be a significant challenge. However, in our view, a relatively benign macro background with the bulk of government borrowing behind us may be an opportune time to try this.
Samiran Chakraborty is the Chief Economist of India at Citibank.
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