Status quo policy with hawkish undertone

On expected lines, the Reserve Bank of India (RBI) has yet again refrained from tinkering with the policy rate. The stance of the policy, too, has remained unchanged — withdrawal of accommodation.

How do we describe the undertone of the policy?

It depends on how we read the RBI Governor Shaktikanta Das’s statement.

He has brushed aside the sudden rise in consumer price index (CPI) inflation, driven by food prices shock, and looked through this as an “idiosyncratic shock” even though he has raised the inflation projection for the current financial year.

The market seems to be happy with the RBI reading that the inflation is not here to stay put. In fact, the bond yield dropped marginally after the policy announcement.

But if we take a long shot, the landscape looks  different. Inflation will continue to remain high even in the next financial year, beginning April 2024. For the first time, the RBI has given its retail inflation estimate for the first quarter of FY25. It’s 5.2 per cent, well above the target.

Since the objective is to bring down the CPI inflation to 4 per cent, in sync with the flexible inflation target, any chance of a rate cut has moved further away — to the second half of FY25, for now. From that standpoint, it’s a hawkish pause.

Let’s take a closer look at the policy.

The repo rate remains unchanged, for the third time in a row, at 6.5 per cent. But since inflation is rising, the RBI’s rate setting body, the Monetary Policy Committee (MPC), will remain watchful and evaluate the emerging situation. In other words, future actions will depend on the evolving data.

The RBI’s bullishness on the growth prospects has remained intact (India is the new growth engine of the world, Governor Das has said) and the real GDP growth for FY24 is unchanged at 6.5 per cent.

The central bank has claimed to have made significant progress towards price stability. However, headline inflation, after dropping to its 25-month low of 4.25 per cent in May, rose to a three-month high of 4.81 per cent in June and is expected to surge in July and August, led by vegetable prices. The vegetable price shock may reverse quickly but possible El Niño weather conditions and global food prices may be a spoilsport even as the progress of the southwest monsoon has been uneven so far.

Assuming a normal monsoon, the RBI has raised its CPI inflation projection for 2023-24 to 5.4 per cent, after cutting it by 10 basis points (bps) to 5.1 per cent in its last policy in June. The inflation projection for the second quarter of FY24 is up by 100 bps to 6.2 per cent; the rise for the third quarter is by 30 bps to 5.7 per cent while the fourth quarter projection remains unchanged at 5.2 per cent. This makes it clear that on the RBI radar the spike in inflation is a short-term phenomenon. One basis point is a hundredth of a percentage point.

For the first time, it has estimated the CPI inflation for the first quarter of FY25 — 5.2 per cent. In other words, the battle against inflation is far from over. As the MPC is resolute in its commitment to aligning inflation to the 4 per cent target and anchoring inflation expectations, the chances of a rate cut are now pushed back to the second half of the next financial year, if inflation evolves the way the RBI is seeing.

While the governor’s statement emphasised the role of continued and timely supply side interventions in limiting the severity and duration of inflation shocks, the RBI is not just watching the inflation trajectory. It has also acted.

As surplus liquidity in the system is a fodder to fuel inflation, the RBI has decided to soak up liquidity by raising the banks’ cash reserve ratio (CRR) or the money that the commercial banks are required to keep with the central bank on which they don’t earn any interest.

However, this is an extremely short-term measure. The banks will have to maintain an incremental cash reserve ratio (I-CRR) of 10 per cent on the increase in their net demand and time liabilities, a loose proxy for deposits, between May 19 and July 28. This is on top of the existing CRR requirement of 4.5 per cent.

The RBI will review the measure on September 8 or earlier to increase liquidity in the system ahead of the festival season.

In November 2016, the RBI introduced I-CRR of 100 per cent to absorb the surge in liquidity in the banking system following demonetisation of high-value notes. At that time, the CRR was 4 per cent. The temporary liquidity management framework was reviewed in December.

A back-of-the-envelope calculation pegs the money that the RBI will absorb through I-CRR between Rs. 1.1 trillion and Rs. 1.2 trillion. Even though it’s a temporary measure, the I-CRR will raise the cost of money for the banks. Let's see whether any bank raises its loan rate following this.

There is always a cost for liquidity absorption. If the RBI does it through its reverse repo window, it bears the cost. Banks borrow money from the RBI at repo rate and keep their excess liquidity with the central bank at the reverse repo rate, which is variable now.

In the past, the government absorbed excess liquidity by selling bonds to the banks under the market stabilisation scheme. In this case,  the government bears the cost.

The CRR is a cost for the banking system.

No bank will complain as it’s a very short-term measure. Early this week, Italy dealt a surprise blow to its banks and sent shock waves across Europe by setting a one-time 40 per cent tax on profits reaped from higher interest rates. We are not going that way even though the banking system is posting record profits in every quarter!

Writes Banker's Trust every Monday in Business Standard. 
 

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