Step towards liquidity normalisation amidst status quo on rates and stance

Step towards liquidity normalisation amidst status quo on rates and stance

Given the contradictory indications on the inflation outlook despite a steadily improving economic recovery, the Monetary Policy Committee's (MPC) October 2021 review and corresponding Reserve Bank of India (RBI) statements were expected.

By a vote of 5:1, the MPC unanimously maintained the status quo on the repo rate and maintained an accommodating monetary policy stance, in keeping with the split witnessed in the August 2021 meeting. The RBI, as expected, refrained from boosting the reverse repo rate without sufficiently preparing the markets. It did, however, take another step toward normalisation of liquidity by pausing the Government-securities acquisition programme (G-sap) and announcing a calendar for the 14-day variable rate reverse repo (VRRR) auctions.

With a softer outlook for food prices partially offset by an increase in edible oil, fuel, and metal prices, as well as input shortages and high logistics costs, the MPC reduced its inflation forecast for FY2022 to 5.3 percent with risks broadly balanced, down from 5.7% in the August 2021 review.

Our own predictions indicate that CPI inflation will average 5.3-5.5% in FY2022, which is only 20 basis points lower than our previous estimate. We remain concerned that rebounding demand may strengthen pricing power, allowing for a more rapid transmission of supply-side pressures to core inflation.

We anticipate the MPC to keep the repo rate and accommodative posture unchanged until demand-side factors become the primary driver of inflationary pressures and begin to harden inflationary expectations, hence fostering the demand recovery. The Committee is likely to choose to look past the recent spike in petrol prices while continuing to press the Government to reconsider fuel taxes.

Despite the fact that GDP growth in Q1 FY2022 fell short of the MPC's projection, the MPC maintained its forecast for a 9.5% expansion in FY2022, boosted by upward revisions to the forecasts for Q2 FY2022 (to +7.9% from +7.3%) and Q3 FY2022 (to +6.8% from +6.3%). Even with 7.9% GDP growth in Q2 FY2022, production will remain slightly lower than it was pre-Covid, as contact-intensive sectors continue to underperform.

The festive season trends and the anticipated Q2 FY2022 GDP growth figure will help determine whether the MPC lays the stage in the December 2021 policy review for a policy stance shift to neutral in the February 2022 policy review or implies another delay.

Soaring energy costs, increased VRRR cut-offs, and market apprehension about an impending reverse repo hike, combined with the October 2021 Policy review, pushed the 10-year G-sec yield to 6.27 percent yesterday, despite the GoI's benign borrowing schedule for H2 FY2022. With rates remaining unchanged in the face of a suspension in the G-sap programme, the 10-year yield crossed 6.3 percent intraday. We now anticipate it to range between 6.25 and 6.4% for the duration of this quarter, unless a sizable OMO purchase is announced for this bucket and crude oil prices fall below US$70/barrel.