RBI Monetary Policy: Steady and bold

Among other things, the policy provides much needed visibility on central bank's balance sheet support for the bond market

The monetary policy review of the Reserve Bank of India (RBI) marks more than one year of living through the COVID pandemic phase that continues to confront social-economic-financial challenges for the Indian economy.

The second wave of COVID will increase uncertainty over India’s near-term growth prospects. This is happening at a time when global financial conditions, led by US rates, have begun to tighten, with few inflation targeting central banks in emerging markets (EMs) such as Turkey, Brazil, and Russia resorting to interest rate hikes in 2021 so far. In addition, Norway has emerged as the first developed country to explicitly signal its plan for monetary policy normalisation by the end of 2021.

In this phase of elevated uncertainty besieged with dichotomous signals, the RBI’s Monetary Policy Committee (MPC) chose to keep its benchmark policy rate unchanged at 4.00 per cent.

The RBI retained its fiscal 2021-22 (FY22) gross domestic product (GDP) growth forecast of 10.5 per cent. While there is a downside risk to near-term growth prospects from the re-imposition of lockdowns in few states, pick up in the ongoing vaccination drive along with improvement in global growth prospects (the IMF recently upgraded its forecast for World GDP growth in 2021 and 2022 to 6.0 per cent and 4.4 per cent from 5.5 per cent and 4.2 per cent earlier, respectively) could limit the downdraft.

In addition, we believe that RBI’s forecast of 10.5 per cent GDP growth for FY22 was conservative to begin with vis-à-vis market expectations – hence, obviating the need for any kneejerk downward adjustment just as yet.

The RBI expects consumer price inflation (CPI) to moderate towards 5.0 per cent in FY22 from 6.2 per cent in FY21. While crude oil prices have hardened significantly from an average of $45 per barrel (bbl.) in FY21 to $62 per bbl. currently in FY22, the same could be offset by a likely hold / reduction in duties on petroleum products, softening of demand due resurgence in COVID infections, and likelihood of a normal monsoon outturn (as per private weather forecasting firm AccuWeather) in 2021.

Monetary policy outlook

Three months into the vaccination process and with commencement of FY22, market participants would start looking ahead for signs of purported shift from the COVID era emergency policy setting. The policy pronouncements and forecasts are in sync with our expectation of a back-loaded normalisation (with first hike in the policy repo rate in Feb-22).

The five-year extension of the flexible inflation targeting framework until March 2026 reinforces monetary policy credibility, which the central bank would seek to preserve as the economy gradually comes out of the COVID shock in H2 FY22. We do acknowledge that recent re-imposition of lockdown restrictions in few states would delay a full-fledged economic recovery, while also making it more uneven. However, the recent pickup in the pace of vaccination raises hope that India would be able to inoculate 50 per cent of its population before the end of 2021 – this would help in significantly breaking the chain of infections and boosting economic activity. The turn in global rates environment and commodity price cycle would further reinforce the need for the beginning of monetary policy normalisation in India.

Implication for markets

From liquidity normalisation perspective, the central bank has already made a beginning, with the two-step withdrawal of 100 basis points (bps) cash reserve ratio (CRR) relief provided in March’20. This juxtaposed with the introduction of the variable rate reverse repo (V3R) auction to temporarily mop up excess liquidity signals central bank’s intent to gradually normalise the liquidity glut, which currently stands close to 4 per cent of NDTL of banks compared to 2.3 per cent as of end March’20.

We expect the RBI to guide liquidity surplus to 2.0-2.5 per cent of NDTL by end March’22, thereby reducing the glut while also ensuring enough remains in the system for frictionless functioning of money markets. This will be crucial for seeing through the elevated borrowing requirements from the central and state governments in FY22.

From a bond market perspective, we highlight two notable developments:

MPC’s reference to time bound forward guidance got omitted in April 2021. Hence, the shift in policy stance would now crucially depend upon incoming growth numbers over the next couple of quarters. Going forward, the bond market could see higher sensitivity to activity data compared to inflation numbers, which is by and large expected to be ranged around 5 per cent levels.

In a bold move, the RBI announced G-SAP 1.0, a secondary market G-Sec acquisition program, whereby the central bank will commit upfront to a specific target for bond purchases to enable a stable and orderly evolution of the yield curve (for Q1 FY22, a target of Rs 1 trillion has been set). This removes uncertainty for market participants given the commitment for absorption of G-Sec supply and should help curb the elevated term premiums and enable efficient portfolio decisions. It would also help to bull flatten the yield curve, in contrast to the bear steepening trend (a source of recent volatility) observed in other markets, and thereby anchor market expectations of long-term rates in the economy.

Overall, the annual policy maintains a steady course, projects improvement in growth-inflation balance, and provides much needed visibility on central bank’s balance sheet support for the bond market.

Vivek Kumar, Yuvika Singhal, Shubhada Rao are with QuantEco Research. Views are their own.