Monetary policy meet: RBI likely to focus on liquidity management

The RBI's 2021-22 growth forecast is likely to remain unchanged at 9.5 per cent year-on-year

In the upcoming monetary policy meeting on August 6, we expect the Reserve Bank of India (RBI) to maintain an accommodative monetary policy stance, citing the need to support the ongoing growth recovery amidst continued uncertainty and global financial market volatility.
 
But the forward guidance is likely to put more emphasis on pipeline inflation risks, compared to past policies. The RBI’s 2021-22 (FY22) growth forecast is likely to remain unchanged at 9.5 per cent year-on-year (YoY), even though there is a high probability of April-June real gross domestic product growth to surprise to the upside, as shown by its own nowcasting exercise (22.1 per cent YoY growth projected versus its official forecast of 18.5 per cent YoY). Our own FY22 growth estimate remains unchanged at 10.5 per cent YoY since the beginning of 2021.

 
The RBI is likely to increase its FY22 Consumer Price Index (CPI) inflation forecast by 50 basis points (bps) to 5.6 per cent, in line with our estimates, even while maintaining the 'transitory hump' narrative. Our nowcasting exercise suggests that CPI inflation has peaked for now and will likely ease below 6 per cent in July, from 6.3 per cent in May and June.
 

But we see risks of India’s CPI inflation stabilising more in the 5-5.5-per cent range over the medium-term, compared to the mandated 4 per cent target. We worry that demand-side inflationary pressure may become more apparent in 2022-23, once a large segment of the Indian population gets vaccinated by the end of FY22.

 
While food inflation risks will continue for India at all points in time, the concern is that core inflation may rise higher and become more persistent over the medium term, as demand-side pressures start becoming apparent. Since monetary policy works with a significant lag, the monetary policy committee should therefore, slowly start looking beyond the current drivers of inflation (led by supply shocks and input price pressure) and factor in the potential medium-term inflation risks.
 
Given that surplus liquidity will increase due to Treasury bill redemptions and G-SAP 2.0 support in July-September, we expect the RBI to increase the absorption of liquidity through variable reverse repo rate (VRRR) auctions route (probably by an incremental Rs 2 trillion for a 28-day tenor). This is, in our view, the 'least-disruptive' method to increase the marginal cost of liquidity absorption, particularly when the central bank is unlikely to take any measures to permanently reduce some part of the large surplus liquidity.

 
It is argued that since the excess liquidity is around Rs 9-10 trillion, taking into account government cash balances, an incremental increase in VRRR will not have any material impact on the current market dynamics. We think that is exactly what the RBI would prefer at this stage, where an incremental increase in VRRR will not rock the boat too much, while at the same time will provide a subtle signal that the RBI remains on course to eventually hike the reverse repo rate and narrow the liquidity adjustment facility corridor to the pre-pandemic spread of 25 bps (we are expecting 40-bps reverse repo rate hike in October-December). No action either to reduce the large quantum of liquidity or to raise the price of liquidity through the VRRR route can lead to unintended consequences of inflationary asset prices, a risk which has been highlighted in the RBI’s latest annual report.

 
If CPI inflation were to stabilise in the 5-5.5-per cent range versus the 4 per cent formal target, what will the terminal repo rate be in the post Covid-19 world? We think it will be about 5.25-5.5 per cent, as potential growth rate of the economy reduces to 6 per cent (from earlier 7 per cent) and the RBI seeks to achieve a neutral real interest rate of zero to +50 bps at most (instead of the earlier 1.5-2 per cent positive real interest rate target). Inherent in our assumption is CPI inflation averaging 5-5.5 per cent in the next few years, relative to the RBI’s target of 4 per cent.

 
The author is India chief economist, Deutsche Bank AG. Views are personal