RBI is preparing the market for reverse repo rate hike

The RBI has calendarized its VRRR auction and stands ready to enhance its duration. This is the first sign of preparing the market for an eventual increase in the reverse repo rate.

“The MPC has a difficult job as it battles both the slowdown and the inflation COVID-19 has triggered”, one MPC member had noted at the August meeting. The monetary policy statement today reveals that India possibly remains in the same spot. The RBI indicated that the “recovery remains uneven” and “critically dependent upon policy support”. On the other hand, the recent inflation outcomes have made RBI more comfortable about the path of inflation than it was in August, despite the recent increases in the global commodity prices. All the above explains RBI’s decision to stay on a pause and retain its “as long as it is necessary” guidance on monetary policy.

A few words on the growth-inflation dynamics from the RBI’s point of view. No doubt the RBI sees some improvements in the domestic economic activity and expects rural demand to remain buoyant with good kharif production and with expectations of a good rabi output. There is also hope that the festive season will bring in some joy for both the contact intensive and the non-contact intensive sectors, a reflection of recovering urban demand. However, the RBI judges that compared to the pre-COVID-19 levels, the lag in the contact-intensive sector is still large while low capacity utilization levels are holding back increases in private investments.

With the actual outcomes of July and August on headline CPI lower-than-anticipated, there is a growing confidence from RBI that inflation will remain within the targeting band. Indeed, the RBI has reduced its inflation projection for FY22 by 40bps with a large downward shift of 80bps for Q3FY22. Having said, the RBI once again makes a fervent plea to the government for a calibrated cut in indirect taxes on petrol and diesel to enable it to anchor inflation expectations and thus, reduce chances of any abrupt policy adjustments, even as demand side story mends itself.

Actions in this policy, and as expected by the market, was on liquidity. The market was looking forward to the RBI for a clear direction on its strategy to address excess liquidity in the system. Especially so, as expectations remain strong on foreign capital flows, and this is likely to have skewed the excess liquidity further. First, the G-SAPs as an option to support and anchor yields in the government securities market is done away with. This has led to a knee-jerk reaction in the 10-year G-sec yields (at 6.31 per cent at the time of writing). However, with the fiscal math getting better and with the need for higher-than-budgeted dated securities borrowing being reduced, I do not anticipate any run-away increase in yields. This view also gets cemented with expectations of lower inflation and a realistic chance of India getting incorporated in a leading bond index.

The attempt to reduce overnight liquidity surfeit comes through tweaks to the Variable Rate Reverse Repo (VRRR) quantum. The RBI has now calendarized its VRRR auction and stands ready to enhance the duration of the VRRR. This is the first sign of preparing the market for an eventual increase in the reverse repo rate and closing the corridor. What the higher quantum of VRRR will do is to push up the overnight operative rate to within the corridor and then, as the reverse repo rate is increased, the market ramifications of the same will be lower.

Indranil Pan is chief economist at YES Bank. Views expressed here are personal.