MPC will pave way for faster policy normalisation

The Monetary Policy Committee (MPC) — in its February meeting — is likely to signal a shift in the policy path ahead, while continuing with a status quo. 

After being in a steady state of decadal-low policy rate for a prolonged period due to the pandemic, the monetary policy has reached an inflection point with a major shift in the global monetary policy setting towards tightening. 

The US Federal Reserve, confronting multi-decade high inflation, has signaled a series of rate hikes in 2022, while the Bank of England has already started raising rates. Domestic economic conditions, however, continue to support an accommodative stance. 

Latest GDP estimates for the current fiscal, while largely in line with Reserve Bank of India’s (RBI’s) forecast of 9.5 per cent growth, paint a picture of an uneven multi-speed recovery, with the largest component of GDP, private consumption, still below the pre-pandemic levels. Average real GDP growth in the last 3 fiscal years has only been around 2 per cent and the case for continuing with the policy support is still strong.

A fiscal policy push to accelerate investments through higher borrowings, has to be complemented by keeping the monetary conditions supportive. And, with CPI inflation moving along the RBI forecast path and stable inflation expectations, a higher weight on supporting growth is warranted.

Crucially, a strong foreign exchange reserves position and manageable external financing requirements provide some space to formulate a policy focused on domestic conditions while preparing to align with tightening global monetary conditions.

A gradual transition in the monetary policy, away from the pandemic-related support, particularly through low rates and large liquidity surplus, is likely to be pursued, starting February. This shift towards normalisation started last year, though without any explicit rate signals. 

A large part of the durable liquidity surplus in the banking system is now being absorbed through variable rate reverse repo auctions, at a rate close to the Repo rate of 4 per cent. That, in turn, has led to higher short-end rates up to 2-5 years, even as an overall accommodative monetary policy stance and the Repo rate were left unchanged. 

However, with CPI inflation expected to rise above the upper tolerance level of 6 per cent over the next couple of readings, before easing gradually towards 5 per cent, and with global tightening gathering pace, the case for an explicit rate signal by hiking the Reverse repo rate by 0.25-0.40 per cent between February and April, is even stronger now. While a demand push on core inflation is still weak, the fact that it is sticky and close to 6 per cent is a risk to headline inflation, particularly once demand conditions improve or if higher input costs see a faster pass-through to output prices. The pace of demand recovery would influence the pace of monetary policy normalisation, going forward.

It is quite likely that over the course of this year, policy stance would be shifted to “Neutral”, durable liquidity surplus levels would be reduced, and the Repo rate would be hiked by 0.50-0.75 per cent, as recovery turns more sustainable. As the MPC signals normalisation, a key challenge for the RBI would be to ensure that even as sovereign yields rise, the move is orderly.

Views are personal