Monetary policy to stay accommodative in near term, but exit is near

The MPC meeting was widely awaited for three reasons. First, to gauge the RBI’s liquidity stance, as the announcement of the variable rate reverse repo auction in early January was perceived by markets as a reversal of the accommodative stance. Second, to assess whether an expansionary Budget would mean less monetary policy support; and third, to seek more clarity on how the RBI would manage the government’s large market borrowings non-disruptively.

On all these counts, the RBI delivered on the dovish side. It reiterated its commitment to ample liquidity and even staggered the impending cash reserve ratio hikes, so that it could inject liquidity via other means, such as open market operations (OMOs). Despite the fiscal activism in the Budget, the MPC stated that the recovery was yet to gain firm traction and needed continued policy support. And the RBI said it would ensure an orderly completion of the borrowing programme.

Yet, there has been market disappointment that the RBI did not take more concrete steps to lower longer-end yields, for example, through an OMO calendar. We do believe that the RBI will step in intermittently via OMOs, but with liquidity already in surplus and the RBI’s forex intervention also adding to the liquidity deluge, pre-committing was never possible.

In the near term, steady as she goes, is the name of the game. Growth has picked up, but has only normalised to pre-pandemic levels. Credit growth is yet to rise materially and excess liquidity is not resulting in any demand-side inflationary pressures.

Sonal Varma

Yet, monetary policy is in transition. As growth continues to normalise, monetary policy will also need to normalise.

The RBI expects real GDP growth to rise 10.5 per cent YoY in FY22. This looks conservative to us. With Covid-19 in check, front-loaded and higher government spending, lagged effects of easier financial conditions, faster global trade and vaccinations, the actual growth outturn should be much stronger — we expect 13.5 per cent YoY.

Inflation is not a risk for now, but underlying price pressures are building up. Higher global commodity prices (from food, oil to other industrial raw materials) amid expectations of steadily firming demand suggest medium-term risks from a gradual return of pricing power will be important to monitor, and cannot be accorded secondary priority for too long. This will require normalising the extent of surplus liquidity. We expect CPI inflation to average above 4 per cent both in 2021 and 2022.

Moreover, with fiscal policy taking a more proactive role in driving growth, the burden on monetary policy should also reduce at the margin.

In the coming months, as growth impulses get stronger, the tug-of-war between the RBI’s motivation to support the bond market (via OMOs) and fundamentals (that call for gradual liquidity normalisation) is set to intensify, in our view. The RBI’s focus will likely shift from nurturing the growth impulses to timing and sequencing the exit, without triggering major withdrawal symptoms. Hence, while policy accommodation stays for now, a new growth and monetary policy cycle is about to begin. Enjoy the ride.

The author is chief economist, India and Asia ex-Japan, Nomura