RBI Monetary Policy: A Hawkish Lurch On Mint Street
“The terminal rate for 2022-23 will go well beyond the pre-pandemic level of 5.15% and closer to or even over 6%.”
The June 8 monetary policy decision undoubtedly falls into the category of ‘aggressive tightening’. The policy rate has been raised by 90 basis points to 4.9% over the last two months while the effective rate increase is even higher if one accounts for the introduction of the Standing Deposit Facility (in place of the reverse repo) – which has raised the lower bound of the policy corridor from 3.35% to 4.65% – implying a total 130 basis points increase.
It is possible to argue that these announcements constitute a marked shift away from an attempt to balance multiple objectives—primarily growth—but launch a frontal assault on inflation. While central banks across the world are ‘frontloading’ rate hikes based on the evidence that monetary tightening works with significant lags, it would probably be wrong in part to see this hefty rate hike and the governor’s statement merely as hurried front-loading.
This aggression ties in with both the central bank’s increased concern around inflation and relative confidence about the strength of domestic growth evident in the June 8 policy statement. To begin with, consider its revised forecasts – the inflation estimate was raised substantially by 100 bps to 6.7% while growth was kept unchanged at 7.2% for 2022-23.
There are some nuances as well. Over the last couple of years, the RBI’s inflation forecasts have tended to be softer than the market’s forecasts. Some would see this as a strategy of playing inflation risks down and focussing on growth. The 6.7% inflation forecast in this policy corresponds to the upper percentile of the professional forecasters’ band, a clear departure from the earlier take.
The big worry for the central bank seems to be the broad-based nature of inflation and the risk of any second-round impacts on inflation expectations, and rightly so. The April inflation print showed that 90% of the CPI basket saw an increase in prices compared to 50% in December 2021. If we see this split just for core inflation – a measure excluding food and fuel – 70% of the basket saw an increase compared to below 40% at the end of 2021.
The good news for now, however, is that signs of a U.S.-style ‘wage-inflation’ spiral remain muted. Rural wage growth has averaged 5.9% over the last quarter – lower than 6.6% in the fourth quarter of 2020-21 and urban unemployment numbers point to some excess supply of labour in the market. Household inflation expectations a quarter and a year ahead also remain manageable. However, with inflation expected to remain above 6% over the next 6-8 months, the feed through to wages remains a key risk. The RBI’s move towards aggressive tightening is to harness the second-round effects of food and fuel inflation that often work through tightening labour markets that tend to push wages and demand up.
Words Matter
One key development in this policy and the press conference that followed was the much-needed clarity on the meaning of the word ‘stance’ of monetary policy. Semantics are important in gauging a central bank’s intentions and it is worth an analyst’s while to parse the policy language.
First, the statement dropped the phrase “to remain accommodative...” and talks exclusively of “focussing on withdrawing accommodation”. Thus, it makes clear that there’s only one way in which policy rates are headed – that is up and liquidity further down.
Moreover, the RBI explained the link between the “neutral” level of liquidity and short-term rates. A neutral level of liquidity is one in which the overnight call rate is exactly equal to the policy or repo rate. If it remains below, the policy is accommodative and liquidity is surplus, if it is higher, there is a liquidity deficit and monetary policy is in a tightening phase. In the current paradigm, liquidity or policy neutrality, an issue much pondered and speculated over by the financial markets, has been delinked from the amount of liquidity. It is instead determined by the wedge between the overnight rate and the policy rate.
Given that the current overnight rate is much below the policy rate, the case for another CRR increase in the future remains strong if indeed high inflation makes neutrality desirable.
Liquidity Management
At what level of liquidity would neutrality hold? Would the RBI have to suck all the Rs 4 lakh crore-plus of liquidity that the system has today? Perhaps not. Given the compulsions of supporting a hefty government borrowing programme and growth supportive needs, the RBI might not want to tack the system to this new “neutral” immediately.
Besides one must not forget that the aggregate liquidity surplus masks the divergence across banks. Large banks with healthy balance sheets have been more active in lending and might have larger liquidity needs going forward. As they borrow more in the call market, the call rate might move closer to the repo rate without a sharp drop in aggregate liquidity. Besides, their liquidity needs might push them to hike their deposit rates as well.
This brings us to the last leg of the monetary policy announcement, which is the familiar dilemma between liquidity management and the government’s borrowing program. A move towards normalisation of liquidity conditions makes it difficult to justify any liquidity infusions through say government bond purchases. However, if one were to read between the lines, the RBI seemed more willing to carry out operation twists (selling at the short-end of the curve and buying at the long-end). Moreover, while the option of plain vanilla open market operations might be off the table, for now, they could be back in vogue if liquidity falls sharply from current levels on the back of say currency market interventions.
Two policy meets ago, the market was concerned about the RBI falling behind the curve. The central become has clearly put those concerns to rest. However, one must recognise that inflation remains primarily a supply-side problem and therefore the capacity of monetary policy to control inflation is limited. This puts the focus now on fiscal measures. Some have already come but a lot more needs to happen if the RBI wishes to see inflation behave in line even with its new revised path.
Abheek Barua is Chief Economist, and Sakshi Gupta is Senior Economist, at HDFC Bank.
The views expressed here are those of the authors and do not necessarily represent the views of BQ Prime or its editorial team.