RBI monetary policy is a stepping stone towards policy normalisation

The monetary policy committee (MPC) of the Reserve Bank of India (RBI) has kept rates on hold and also decided to continue with the accommodative stance as long as necessary to revive and sustain growth on a durable basis. However, this policy had many more nuances that foretell the shape of things to come.

While the fiscal 2021-22 (FY22) growth forecast has been retained at 9.5 per cent, there is a shift with Q1 growth revised upwards to 21.4 per cent (18.5 per cent earlier). Growth forecast for the remaining three quarters has been lowered. Growth commentary is more positive than last policy with rural demand expected to be resilient, exports expected to continue to do well and pick-up in the long awaited capex cycle. In fact, the central bank has supplemented this with a growth forecast of 17.2 per cent in the quarter ending June 2022, when India is likely to come out of the Covid-19 pandemic.

On the inflation front, RBI has increased its inflation estimate for FY22 to 5.7 per cent from 5.1 per cent earlier. The upward revision is spread out across the year. CPI inflation for quarter ending March 2022 is now estimated at 5.8 per cent from 5.3 per cent earlier. In fact, inflation in the quarter ending June 2022 is also expected to remain above RBI’s target of 4 per cent at 5.1 per cent. Inflation remains a supply-side driven factor, given the increase in international commodity and oil prices leading to a pass-through into domestic prices. Some of the food items, such as edible oils and pulses, are facing persistent inflation, though moderating now. However, firms are yet to pass-on increase in underlying input costs due to weak demand. This will change as growth and consumer confidence revives.

At the same time, liquidity in the system continues to go up. Total absorption through reverse repos surged from a daily average of Rs 5.7 trillion in June 2021 to Rs 6.8 trillion in July 2021 to a staggering Rs 8.5 trillion in August 2021. Accordingly, the RBI has decided to increase the size of its variable rate reverse repo (VRRR) auction to Rs 4 trillion on September 24, 2021 from Rs 2 trillion currently. Notably, VRRRs were temporarily withdrawn during the pandemic and were restarted only in January 2021. This can be construed as a first step towards absorbing liquidity at the short-end and reducing the term spread as growth revives. At the longer-end, RBI will be providing liquidity support through operation twist and GSAPs.

Our assessment is that the RBI policy is a stepping stone towards policy normalisation, if another wave of Covid-19 doesn’t hit us. Growth is recovering with a number of high frequency indicators across sectors—consumption, exports, government revenues and capex—showing economic activity is improving. Certain contact intensive sectors continue to be negatively impacted. Inflation is gradually coming down from 6.2 per cent in FY21 to 5.7 per cent in FY22. It is expected to come down further in FY23 to close to 5 per cent. However, it remains above RBI’s target of 4 per cent.

Given the inflation and growth trajectory, the RBI is likely to reduce the rate corridor between reverse repo and repo rate in the quarter ending March 2022 before lifting off repo rate at the beginning of the next financial year.

Sameer Narang is chief economist at Bank of Baroda. Views expressed are his own.