Liquidity normalisation is upon us

The path of the economy’s recovery over the past few months has validated the gradualist approach taken by the Reserve Bank of India (RBI). Growth prospects have brightened and inflation outlook has eased, despite lingering concerns as to potential broad-based supply shocks.
 
The latest Covid-19 wave is under control and the vaccination drive has reached warp speed — at the current pace, the country is on track to administer 1.7 bn jabs by the end of the year, which will cover a large majority of India’s eligible adult population. This backdrop sets the stage for the withdrawal of the extraordinary monetary policies implemented during the pandemic to support the economy.

 
High-frequency indicators over the past two months show recovery gaining momentum, led by manufacturing output, while the services sector continues to lag the rebound. Trade volumes are now above pre-pandemic levels, freight traffic continues to hold up, and tax revenues are showing signs of buoyancy.
 

The broader economy should also benefit from the tailwinds of stronger export orders, the unleashing of pent-up consumption demand and inventory rebuilding. Apart from the likelihood of higher growth forecasts, we think these factors alone will see the RBI expressing confidence in the recovery.
 
Helping this view is the inflation trajectory, which has started to turn down. The usual seasonal correction in food prices has begun, which should see food inflation dip below 2 per cent in the coming months, and help to push headline inflation below 4 per cent. While demand-side price pressures remain subdued, there is unlikely to be any respite from imported and input cost-driven price increases.

 
We are already witnessing a series of price shocks including one-off hikes in telecom tariffs, motor vehicle prices and tuition fees, which are likely to keep core inflation elevated. In addition, household inflation expectations have risen to their highest levels in more than three years. Taken together, these evolving price risks will likely ensure the MPC maintains its vigilance over the inflation trajectory, even if the near-term outlook appears benign.
 
RBI’s liquidity management framework has undergone several major shifts in the past decade. After the preference for deficit liquidity conditions under Dr. Raghuram Rajan, Governor Shaktikanta Das has preferred to keep liquidity conditions in a surplus state. This approach seems to have been vindicated in the current circumstances, given the improved transmission of monetary policy changes, and increase in credit flows to the economy. Indeed, we think the provision of surplus liquidity over the past 18 months has been one of the most important factors in nurturing the growth recovery. However, all such actions come with an expiry date, and we believe the dawn of liquidity normalisation is upon us.

 
The tapering of liquidity injections is already underway — with operations ‘twist’ likely the preferred tool to this end. Autonomous liquidity drivers such as currency outflows and capital inflows are likely to largely cancel each other out, even as the drawdown of government cash balances boosts system liquidity. This leaves little room for the liquidity-sensitive central bank to undertake standalone OMO purchases.
 
However, that does not mean that the RBI is in a hurry to drain liquidity. Deputy Governor Michael Patra in a recent speech emphasised that the central bank will rely on natural liquidity drainers such as increasing credit demand and currency outflows. We think the active withdrawal of liquidity support will be accompanied by the increased use of price-based tools. In our view, reverse repo rate hikes are likely from December, while repo rate hikes could take place in the next fiscal year.

The author is Chief India Economist, Barclays. Views are personal.