RBI monetary policy: How to ease without cutting rates

The Reserve Bank of India (RBI) and its monetary policy committee (MPC) delivered a dovish policy package despite keeping policy rates unchanged.
 

With inflation above 6% for many months and high-frequency indicators suggesting that the economy has embarked on a recovery path, the macroeconomic backdrop going into the October policy meeting would have suggested prioritisation of inflation over growth.
 

However, this is far from the truth and the MPC has rightfully set the record straight by stating that it views current inflation as transient, whereas growth revival needs policy focus.
 

No doubt headline inflation is running close to 7%, but digging deeper into the details shows that it has been entirely supply-side driven: higher taxes on alcohol and fuel; higher commodity prices such as gold, silver and petrol that also feed into core inflation, unseasonal rains driving vegetable prices and the various bottlenecks triggered by the lockdowns, including labour, logistics, among others.
 

A better measure of underlying inflation is a trimmed mean, which excludes 10% of each of the highest and lowest CPI inflation components each month. This measure is a shade below 5% and has been falling in recent months, suggesting that current high inflation is not broad-based.
 

Meanwhile, growth is indeed picking up from its April lows, but most sectors are still clawing their way back to the pre-pandemic normal. The path ahead also remains uncertain because it is closely tied to the path of the pandemic curve. Consumers may remain cautious on spending due to slower income growth and higher income uncertainty. Balance sheets of corporates and banks remain under pressure. All of this suggests that the current growth revival is encouraging, but the economy is not yet out of the woods.
 

In this background, the MPC’s strong forward guidance to maintain an accommodative stance as long as necessary and its statement that as inflation eases it will use the policy space to support growth, sends the right signal, in our view.
 

Meanwhile, policy transmission has occurred this year, but two challenges remain. First, elevated credit risk has prevented specific sectors from access to funding. The on-tap targeted long-term repo operation is geared towards addressing this risk. Second, market concerns on high central and state government borrowing have resulted in elevated term premium. The RBI’s announcement to conduct open market operations for both central government and state development loans (SDL) will likely ensure the term premia compresses and SDL spreads also narrow.
 

Finally, high inflation had led to fear in some quarters that the RBI would correct its easy liquidity stance. The RBI again, correctly, dismissed such concerns.
 

Overall, the combination of lower for longer forward guidance, commitment on liquidity and measures to support the bond market will ensure that the process of policy transmission is not disrupted, but is in fact reinforced, despite an unchanged policy rate. Hence, the RBI has managed to deliver more than what a simple rate cut would have achieved.

Sonal Varma is the Chief economist for India and Asia ex-Japan at Nomura.