Expect RBI to keep accommodative stance at least till first half of FY22

With FY22 Union Budget announcing a higher-than-anticipated fiscal deficit target and market borrowing programme, bond market sentiments have soured, with 10-year government bond yield rising above the 6 per cent mark.

Against this backdrop, the upcoming monetary policy will gain importance, to ascertain the reaction function of the Reserve Bank of India. While the MPC is expected to maintain the status quo on the rates front, the focus will be primarily on three factors: i) till what time period the MPC will want to maintain its guidance of accommodative stance; ii) how actively the RBI will want to support the bond market to prevent longer-term yields from inching higher; and iii) what will be the RBI’s strategy going forward regarding liquidity management beyond conducting the Rs 2 trillion variable rate reverse repo auction since last month.

 

With CPI inflation having come below 5 per cent in December, the MPC members will express comfort regarding the easing of food inflation and signal their intention to exit from the extraordinary monetary accommodation in a very gradual and phased manner, in line with their guidance of maintaining the accommodative stance even into the next fiscal year. We think the MPC could express its willingness to maintain the accommodative monetary stance at least till H1FY22, which should help sentiments.

We expect the RBI to revise its inflation forecast downward for Jan-March 2021 to 5 per cent (from 5.8 per cent earlier), while maintaining the April-Sep forecast of 5.2-4.6 per cent. We do not expect the central bank to change its growth forecast (-7.5 per cent YoY for FY21) at this stage.

The central bank will likely guide the market that it stands ready to support the government’s increased borrowing programme so as to ensure smooth functioning of markets and to arrest any unwarranted or excess volatility. But we expect the demand backstop via OMOs to reduce, driving a repricing higher of yield ranges eventually. The central bank will probably remind market participants that the yield curve is a public good and that it is the responsibility of all stakeholders to ensure smooth functioning of the government’s borrowing programme.

 

As far as liquidity operations are concerned, we expect the RBI to say that liquidity will remain more than adequate to support growth and that the central bank is in no hurry to reduce the quantum of excess liquidity materially, particularly as the excess liquidity is still not posing as a risk for build-up of demand-side inflationary pressures at this stage. We do not expect the central bank to confirm whether the 100bps CRR reversal that is expected to happen in end-March 2021 will be extended further or not; the decision will likely be taken in end-March depending on the evolving liquidity conditions at that stage. In this regard, it should come as a relief to market participants that the government has not announced any Market Stabilization Bonds in the Budget for the RBI to draw out excess liquidity.

We are not sure whether the RBI will announce a Standing Deposit Facility as has been expected for some time now, against the backdrop of persisting foreign capital inflows. However, this still remains a possibility.

Finally, we expect the MPC to commend the government in unveiling a credible growth-supportive Budget, which will help support the ongoing recovery through FY22. We expect the monetary policy to continue playing a complementary role to fiscal policy, as long as i) the negative output gap does not close meaningfully; or/and ii) inflation does not appear to be a serious threat.

 

The author is India chief economist, Deutsche Bank AG