Beyond rates: Five things to watch out for in RBI's monetary policy

The monetary policy committee's commentary on inflation, growth and bonds is of much interest to the market.

Most economists expect the monetary policy committee (MPC) of the Reserve Bank of India (RBI) to keep the repo rate unchanged for the seventh time straight and continue with an accommodative stance after a review meeting ending Friday. That being likely the market will want to know the central bank’s thinking about the economy in the coronavirus pandemic. Here are five things to know about RBI’s monetary policy.

Normalising policy

The RBI has continued with an ultra-loose monetary policy that keeps interest rates lower than average inflation while maintaining a huge amount of surplus liquidity. The market wants to know whether the RBI will indicate on Friday when it will start returning to normalcy.

What is normal is viewed differently but among other things, it is the gradual withdrawal of liquidity, inching up of overnight rates and narrowing the policy rate corridor.

“I think it is too early for the RBI to start normalising the policy. For normalising the policy, the MPC will wait for hard data on (Covid-19) vaccination coverage--that is say, when around 50% of the total population is fully vaccinated. That will give them more confidence on the durability of growth,” said Anubhuti Sahay, head of economic research, South Asia, Standard Chartered Bank.

India’s Covid-19 vaccination--key for MPC members to be confident about sustainable growth--has been slow due to production glitches. The government’s target to inoculate the entire eligible population by the yearend is seen as rather ambitious given the current pace of vaccination.

In past monetary policy reviews, the RBI has said the accommodative stance will continue as long as necessary to revive and sustain growth.

“The MPC meets at the cusp of a visibly sticky inflation, nudging growth phase and a fluid pandemic situation world over,” said Lakshmi Iyer, CIO (Debt) & Head Products, Kotak Mutual Fund.

“The central banker is mostly likely to maintain a status quo on rates, being mindful of growth and wait for more data points on the inflation front. There could be some steps towards normalisation of liquidity via increased tenor and/or quantum of VRRR (variable rate reverse repo)--something which bond markets seem to be anticipating,” she said.

Inflation forecast

Consumer-price index-based inflation--the RBI’s yardstick to make policy --has stayed above its tolerance zone in May and June. This may prompt the committee to revise the inflation forecast for this financial year, according to market experts. In the policy review meeting in June, retail inflation was estimated to be 5.1% for 2021-22: an upward revision from the previous policy statement. 

“We expect the RBI MPC to look through the transitory hump in inflation…and stick with a unanimous dovish pause in the upcoming 6th Aug policy. The MPC is likely to revise up its FY22 average CPI inflation forecast slightly from the previous 5.1% and flag potential upside risks,” said BoFA Securities in a note.

Analysts said the central bank would probably look through the spike in recent inflation citing supply side disruptions, viewing such upswings as not warranting monetary policy intervention.

Growth revival

Economic activity has revived in the country since the last monetary policy review conducted in the backdrop of local lockdowns to slow down the second wave of Covid-19 infections. That wave led the central bank to prune down growth forecast to 9.5% in June, from 10.5% projected before.

“Since the last rate review in June, policymakers have had two months’ of inflation prints on hand and a host of high-frequency indicators that signal that the economic momentum has largely recovered from the slump caused by the second wave of the pandemic,” said Radhika Rao, Senior Economist, DBS Bank.

The market expects the monetary policy to retain growth forecasts on Friday.

“We expect FY22 real GDP growth forecast to be retained at 9.5%, with risks evenly balanced at this juncture. The RBI Governor is likely to reiterate a dovish message and argue against a hasty withdrawal of monetary policy support,” said BoFA Securities.

Yield curve

The RBI and the bond market disagreed over bond yields in the pandemic, particularly on the 10-year paper. The RBI wanted to keep yields low despite higher supplies, but it now seems to accepted the macroeconomic reality. A new 10-year government bond was introduced last month, with yields higher than the previous one. The yield on the 10-year paper has inched up another 10 bps since then, ending at 6.20% on Tuesday. Market participants see this as a higher tolerance from the central bank as earlier there was an effort to maintain the yield at 6%.

RBI, however, has emphasised on an orderly evolution of the yield curve since the tug of war broke out.

“It is important that the supply pressure in the bond market is allowed to be reflected in the prices but at a very gradual pace. Because if they keep it suppressed for a long time then it could lead to very sharp moves in a very short span of time later on, which can result in another round of challenges for market participants,” said Sahay, the Standard Chartered expert.

“Yield curve and liquidity management will remain policy focus. The RBI will again assuage markets and continue to ensure that no premature tightening of financial conditions would happen and yields uptick is managed smoothly. Markets would watch any hint on GSAP 3.0 and choice of securities mix,” said Madhavi Arora, Lead Economist, Emkay Global Financial Services.

Rs 10 trillion excess liquidity

Excess liquidity in the banking system is another issue that the MPC may comment. This surplus liquidity of around Rs 10 trillion rides on the back of slow government spending and robust inflows, and sluggish credit demand.

“Normal liquidity, which is the daily operational liquidity, is about Rs 6 trillion only. My belief is RBI more monitoring the normal liquidity than the system liquidity,” said Indranil Pan, chief economist at YES Bank.

The market does not expect withdrawal of the excess surplus soon but will see how RBI perceives it.

“Market might watch out for any indication on how RBI plans to manage the huge amount of surplus in the system. Not in terms of action but some commentary on how RBI perceives the current level of excess liquidity in the banking system. A more opportune time is likely to be used to take away the excesses,” Sahay said.

The market has factored in status quo on rates and an accommodative stance, but RBI Governor Shaktikanta Das’ comments may make the policy review interesting to read. 

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