Run-up to monetary policy review: Nudging but not rocking the boat

Monetary policy setting is undoubtedly challenging when the growth forecasts have to be revised downwards, but the opposite has to be done for the inflation forecasts as the energy and food price shocks pass through the system. RBI MPC is going to be presented with a similar dilemma in the April meeting. On top of it, while the primary source of the rise in inflation forecasts would be “supply side”, the characteristics of inflation embodied in the 3 P’s of persistence, pervasiveness and perception are now demanding the attention of monetary policymakers. With growth forecasts likely in the range of 7-7.5 per cent for FY23, slack in the economy may persist for the entire year but the MPC needs to carefully consider why this is coexisting with elevated core inflation.

In the April policy, a change to a “neutral” stance will provide the MPC with more operational flexibility to move in case the inflationary pressures intensify but the RBI might opt for a more calibrated modification of the forward guidance by altering the relative weights of growth and inflation, rather than an outright change in stance to “neutral”. There is a possibility, though, that the MPC finds a suitable expression for their new stance, which is somewhere in between “accommodative” and “neutral”.

Another issue that the RBI will be grappling with is whether the stance can be changed to “neutral” when there is a surfeit of liquidity in the system. We note that, quietly but steadily the RBI has been reducing the Durable Surplus Liquidity in the system by at least Rs 3.3 trillion in the last six months, resulting in the RBI’s balance sheet contracting by Rs 2ppt of GDP from the peak. This is already reflecting in incremental tightness of financial conditions in money and rates markets. The RBI will feel that if there was any contribution of monetary factors to inflation, then they are gradually addre­ssing them and, in fact, they might be ahead of other central banks in this regard.

Markets will also be keen to hear the RBI’s guidance about OMO purchases to ease out the pressure of large government borrowings in H1FY23. Based on historical patterns, the OMO support required in H1 could be Rs 2-2.5 trillion (25-30 per cent of gross issuances). Although we would agree that pre-committing a GSAP might be difficult given the inflationary backdrop, the RBI should provide some comfort on restarting OMOs in a somewhat liquidity neutral way. A clear articulation that monetary policy cannot be the first line of defence if the inflation problem is supply side and there is no urgency to get back to the medium term inflation target of 4 per cent, may impart additional dovishness to the policy. However, if the RBI alludes to the need for correcting the persistent negative real policy rates or hints at elevated current account deficit as additional risks to macro stability, then market expectations about monetary policy normalisation might have to be advanced. On balance, while markets have been agitated over the macro implications of repeated supply side shocks, it is likely that the RBI will continue with its calming influence in the April policy, too. 

Views are personal