Monetary Policy: As MPC Signals Prolonged Pause, RBI Offers LTRO, Limited CRR Exemption As Support
The status quo on rates is likely to prevail for at least six more months on high inflation, writes Gaurav Kapur.
The Monetary Policy Committee in its last meeting for the current financial year acted along the expected lines by keeping the repo rate unchanged at 5.15 percent while continuing to maintain an accommodative policy stance. With the latest print of headline Consumer Price Inflation Index well above the upper tolerance band of the target range of 2-6 percent and expected to remain above that level over the next quarter at least, a status quo on policy rates was almost a foregone conclusion.
Acknowledging the recent food-driven spike in headline inflation, the Reserve Bank of India now sees it remaining above the 4 percent target over the first three quarters of calendar-year 2020. Outside the use of monetary levers to support growth, key policy measures aimed at easing supply of credit to key and stressed sectors and a long-term repo window for banks for a provision of durable liquidity of Rs 1 lakh crore, were announced. The RBI also announced a fine-tuning of its liquidity management framework to make it more efficient while keeping its main contours unchanged, with the weighted average call rate or WACR remaining the operational rate for monetary policy.
Growth-Inflation Dynamics
The growth and inflation forecast path underlying the MPC’s decision to keep the repo rate unchanged shows that the RBI expects headline inflation to peak in the Q4FY20 and ease gradually over the next three quarters, while real GDP growth would pick-up gradually over FY21. Real GDP growth is projected at 6 percent for FY21, with 5.5-6 percent in H1FY21 and 6.2 percent in Q3FY21. Growth for the current year has been retained at 5 percent, down from 6.1 percent in FY19.
This growth forecast path suggests that the Indian central bank expects the economy to grow below potential for a third consecutive year.
Meanwhile, CPI inflation is projected to rise to an average of 6.5 percent in Q4FY20, up from 5.8 percent in Q3FY20 and then ease to range between 5 percent and 5.4 percent in H1FY21 and further to 3.2 percent in Q3FY21. Risks to this forecast path are seen as evenly balanced but the outlook on inflation is seen as highly uncertain. Higher vegetable prices, the main driver of inflation in recent months, are expected to ease but non-vegetable food items like milk and pulses, are expected to see upward price pressures, providing an upside bias on food inflation. Cost-push pressures to core inflation are also expected, from higher mobile tariffs and prices of essential medicines and new emissions norms driven increase in automobile prices.
On the growth front, rationalisation of personal and corporate income taxes and other measures announced in the Budget to boost the rural economy and infrastructure, are viewed as imparting a positive impetus. Improving monetary transmission of past rate cuts helped by external benchmarking of loans along with a pick-up in the flow of funds to the commercial sector in Q3FY20 and easing of global trade uncertainties are identified as the other key positive factors for economic activity.
Guidance on policy rates, based on this assessment of growth and inflation dynamics, indicates that while the MPC does see space for the repo rate to ease in the future, a pause is likely to be maintained, as long as the headline inflation is expected to hold above the 4 percent target. While the outlook on inflation has been characterised as highly uncertain, easing of household inflation expectations, subdued input and output prices pressures, weak demand outlook and falling capacity utilisation in the manufacturing sector, seem to suggest that inflation will ease during the first half of FY21 and settle closer to the 4 percent target by the second half. That, in turn, would allow for further easing of the repo rate to support growth. In the interim, the MPC is expected to remain on a prolonged pause.
Credit Supply Measures
While awaiting transmission of past rate cuts to the market and bank loan rates at large, the RBI announced important measures aimed at reviving non-food credit growth and directing its flow to key sectors of the economy. To direct the supply of bank loans, incremental credit in the form of retail loans for autos and residential housing and loans to MSMEs—for a period of 6 months—has been allowed to be set-off against the banks’ CRR requirement. That would help improve credit supply to these sectors, by increasing the availability of lendable resources and reducing the cost of funds.
However, considering the general risk aversion prevailing among lenders, incremental credit supply will only improve gradually. In the case of vehicle and housing loans, the credit growth rate is reasonably strong already, but loan growth to the MSME sector is weak.
The RBI also announced that starting mid-February it would be conducting long-term repo operations for tenors of one and three years, to inject durable liquidity in the banking system of up to Rs 1 lakh crore, at the prevailing repo rate. This new liquidity window will provide banks access to cheaper funding from the RBI for longer tenors and will in turn help bring down rates, across different classes of borrowers, especially the government, in tenors up to three years. Indeed, following this announcement, the yields in the government bonds in these tenors have eased, with the 3-year yield easing by almost 20 basis points. Lower yields on government bonds would also allow for lower yields on corporate credit and help reduce their cost of borrowings.
The access to LTRO however, would depend upon the excess SLR holding for banks and their Liquidity Coverage Ratio levels.
Liquidity Management
The other major policy decision announced relates to the operational mechanism of the RBI’s liquidity management framework. Liquidity operations of the RBI aim to ensure that the operational rate, WACR, is aligned to the policy rate (repo). Based on the review of an internal working group, the RBI has decided to do away with the quantitative ceiling of 1 percent of banks’ net demand and time liabilities for the provision/absorption of liquidity from the banking system. This change in approach on quantitative target of banking system liquidity is already visible from the current surplus in the system touching levels last seen during demonetisation.
To fine-tune the operations further, a 14-day variable rate term repo will be conducted every reporting fortnight, while the daily fixed rate repo and other 14-day term repos have been discontinued. Thus, the assured liquidity support at 0.25 percent of banks’ NDTL from fixed-rate daily repo operations has been discontinued.
The framework aims to reduce the frequency of RBI’s liquidity operations, while ensuring appropriate liquidity conditions in the banking system, not bound by any quantitative ceiling anymore.
In summary, while the MPC has had to maintain a status quo on rates which is likely to prevail at least for six more months on high inflation, the RBI has moved to directing credit flow and providing durable liquidity to banks beyond the near-term, to help improve overall credit market conditions. With monetary policy reaching a limit in terms of its effectiveness to push growth through lower rates and abundant liquidity, a different approach was required to push the flow of credit. The measures announced aim to do just that by extending the liquidity support through LTROs and by providing a time-bound sector-specific CRR exemption.
Gaurav Kapur is the chief economist at IndusInd Bank. Views are personal.
The views expressed here are those of the author and do not necessarily represent the views of BloombergQuint or its editorial team.