Monetary policy: All eyes on RBI for orderly evolution of yields

The Monetary Policy Committee (MPC) in its first meeting for the new fiscal year is faced with a different set of challenges it needs to address, as it looks to calibrate the monetary levers to keep inflation anchored to the recently renewed target of 4 per cent.
 

Overall policy focus will remain on supporting growth through low and stable interest rates and abundant liquidity. With the country undergoing a second wave of Covid-19 pandemic, economic activity, which otherwise has been improving steadily, would be affected as movement restrictions are reimposed. Moreover, with a real GDP de-growth in the previous year, the economy continues to operate with a slack with key variables like private consumption, capacity utilisation, exports and overall supply conditions, only gradually returning to pre-Covid levels.
 

While growth in the new fiscal year could be well over 10 per cent, considerable uncertainty remains in the face of the pandemic and potential output loss over a longer term. Thus, the MPC is likely to keep the repo rate unchanged and retain an accommodative monetary stance. However, with core inflationary pressures elevated and headline CPI inflation likely to stay well above the 4 per cent target in the first half, any upside risks to inflation spike will be closely tracked.
 

The flexible inflation target framework extended until March 2026, however, has the inherent flexibility to help growth, given the upper tolerance level of 6 per cent for CPI inflation.
 

To ensure that monetary conditions remain accommodative, and rates remain supportive for growth, the RBI may have to step up its intervention in the sovereign bond market through open market purchases. Helping the government manage its large market borrowings, at a reasonable rate, will be a major challenge, at least over the first half of the fiscal year.
 

In the last fiscal year, the RBI bought government bonds worth over Rs 3 trillion to support record market borrowings by the government. In fact, the weighted average cost of borrowings last fiscal year, at 5.79 per cent, was the lowest since 2004-05. In this fiscal year, with banks’ holding almost 12 per cent of their NDTL as excess SLR and given the likelihood of a pick-up in bank credit offtake, the appetite to absorb another large net supply of Rs 9 trillion, could be lacking. Moreover, given that the sovereign yield curve acts as the base curve for the cost of borrowings for other borrowers, any sharp spikes in G-sec yields would lead to higher interest rates across the economy. That, in turn, may hamper the nascent recovery in economic activity, especially as investment activity is finally beginning to show green shoots. Mindful of that fact, the RBI has been calling for an orderly evolution of the yield curve. Thus, in pursuit of that objective, the central bank may either announce the size of its monthly bond purchases for the first half of the fiscal or even release a monthly calendar of bond purchases to coincide with the government’s borrowing of Rs 7.2 trillion. Accommodating an expansionary fiscal policy aimed at pushing investment activity, will be a key influencer of monetary policy actions over the first half.
 

Another area that the MPC would monitor closely is the sharp spike in the 10-year US treasury yield on the back of rising inflation expectations following a record fiscal stimulus already announced and planned by the US government, on top of ultra-loose financial conditions maintained by the US Fed. That can lead to bouts of capital outflows, asset market sell-off, and pressure on the rupee exchange rate and on imported inflation. Sizeable foreign exchange reserves of $580 billion, covering almost 18 months of imports, will help in absorbing any depreciation pressures. That, in turn, would help ensure that monetary policy can focus on growth without having to change its stance or course due to external conditions.
 

In conclusion, in pursuit of growth, which is currently being driven by government spending, MPC is likely to maintain a status quo on rates with an accommodative stance. Keeping government borrowings costs from rising sharply, will be the primary goal for the RBI. Forward guidance through FY22 growth and inflation forecasts will help provide signals for any future policy changes.
 

The author is chief economist, IndusInd Bank