RBI monetary policy: Evolving trade-offs warrant deep analysis

Before the Union Budget projections for FY23, we had pencilled in a formal start of monetary policy normalisation in the forthcoming February review, with a small rise in the reverse repo rate

Before the Union Budget projections for financial year 2022-23 (FY23), we had pencilled in a formal start of monetary policy normalisation in the forthcoming February review, with a small rise in the reverse repo rate. Now we are not sure, leaning toward the view that RBI will choose to postpone the formal normalisation start till April.

India will face much tighter external financial conditions in 2022. Many of the G-10 central banks are expected to start raising their policy rates and roll down their balance sheets. The US Fed has been communicating an aggressive tightening, although recent data prints suggest that the rate hikes will be more moderate.

IMF forecasts a slowdown in global economic and trade growth in 2022. Our view is that India’s real gross domestic product (GDP) will grow at 8.3 per cent in FY23, after an expected 9 per cent this year. China remains a wildcard, with signs of a marked slowdown, and policy stimulus likely resulting in some further hardening of metals and ores prices. Crude oil markets are likely to remain tight in 2022, particularly with reviving travel. Prices are likely to remain significantly above the $70-75 per barrel forecast in the Economic Survey.

Consumer price index (CPI) inflation in India is expected to moderate from an average 5.4 per cent in FY22 to 4.8 per cent in FY23, but there are many upside risks, both global and domestic. Logistics bottlenecks are unlikely to significantly ease till the middle of 2022. If domestic recovery is quicker and more broad based, this is also likely to result in input costs passed on to end user prices. In this context, the expenditure proposals in the Union Budget might influence aggregate demand.

So will RBI start hiking the reverse repo (RR) now? Should it? RBI has indeed adroitly managed a smooth guiding up of short term rates since September 2021, using weighted average and cut off yields at variable rate reverse repo (VRRR) auctions. One view is that this has obviated the need for an immediate hike in the RR rate. This will prevent further volatility in longer-term interest rates along the yield curve, already disconcerted by the borrowing programme of the Centre.

On the other hand, state government borrowings will add to the supply. Demand for bonds is unlikely to be robust next year in a rising rate environment. India’s inclusion in global bond indices in the near horizon remains uncertain. The expected additions to system liquidity and non-banks’ inability to access RBI’s RR facilities will keep a substantial corpus priced at the RR rate or below, creating some distortions. If aggregate demand picks up, capacity tightens and inflation goes above our forecast, this might necessitate a steeper and compressed policy tightening trajectory (a la the Fed), which will impact interest rates. With credit demand appearing to be improving, this might result in faster transmission to bank lending rates, particularly to the critical MSME segment. The Monetary Policy Committee will evaluate the multiple tradeoffs determining the optimal sequencing of policy normalisation.

Bottom line? RBI will hold the RR rate, but we think a start of normalisation with a small hike is now warranted.

Views are personal