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RBI may remain accommodative for some time now but will act on liquidity, bond market says

RBI may remain accommodative for some time now but will act on liquidity, bond market says

17 Sep 2021

NEW DELHI: The Reserve Bank of India will detail its next monetary policy statement in just about three weeks from now and barring any unforeseen events, domestic and global, the central bank has received most of the major data sets that may influence its rate decision.

Data for India’s GDP growth in April-June and latest data on consumer and wholesale price inflation and India’s industrial output have all been released. The data paints a rather straightforward picture.

GDP growth in April-June, while registering a record high of 20.1 per cent, was short of expectations of both the market and analysts, given a hefty boost by a favorable statistical base effect.

While India’s industrial production showed a sharper-than-expected rise of 11.5 per cent (year-on-year) in July, a closer look at the data shows that the recovery was uneven with analysts saying that the manufacturing sector still faces headwinds.

Cut to inflation. Headline retail inflation, which is RBI’s monetary policy anchor, eased to 5.30% in August data released earlier this week showed. The August CPI inflation reading was well below analyst estimates which had placed the price gauge at around 5.60% for the month.

With July’s CPI print of 5.59 per cent bringing the average headline inflation reading to 5.44 per cent so far in July-September, it seems a foregone conclusion that the RBI’s own estimate of 5.9 per cent for the current quarter will be undershot.

So far, the takeaways seem fairly clear – inflation is easing from the highs witnessed earlier this year while growth still needs help to recover from the blows suffered from the COVID-19 crisis.

The clear-cut conclusion is that the central bank will continue with policy accommodation and on that count, there seems to be no doubt.

What is telling though is how markets reacted to the lower-than-expected CPI inflation number for August.

Ordinarily, such a favorable inflation outturn would have been viewed as a harbinger for more monetary largesse, but markets did not seem to be overjoyed.

Equity markets barely registered a reaction, while the sovereign debt market – which typically is very sensitive to inflation numbers, also did not budge.

Bankers and treasury officials who spoke to ETMarkets.com flagged a few reasons.

Firstly, central bank officials, including RBI Governor Shaktikanta Das, have over the last few weeks, have spoken at length at meetings (both public and private) about the need to sustain growth but have also said that the process of normalization from ultra-loose monetary policy is on the cards.

While the central bank has made it very clear that it will telegraph its moves very clearly to markets, the takeaway is that normalization is undoubtedly being discussed on Mint Street and that as far as interest rates are concerned, there is only one direction in which they are likely to move – northward.

“We are fully conscious and will not try to make any changes which take the market by surprise…as I have said earlier and I would like to repeat – all our actions will be calibrated, they will be well-timed, they will be cautious and they will keep in mind aspects like what you are mentioning. We don’t want to give any sudden shock or any sudden surprises to the markets,” Das said in a recent interview.

There is no doubt that the shift from the crisis response that the central bank adopted in response to COVID will take time but what has happened with the recent flurry of central bank interactions is that all the good news has been priced in.

Rather, the debt market has now made its peace with the inevitability of the central bank moving towards normalisation.

While it is unlikely that the benchmark policy repo rate will be lifted any time before the next calendar year, what will certainly be tackled is the huge surplus of liquidity in the banking system.

The traditional channel of bank credit certainly is not posing threats as far as inflation is concerned right now but there are other ways in which the excess liquidity poses challenges, the most obvious one being asset price bubbles.

Sectors such as real estate have benefited strongly from the low cost of borrowing brought about by the huge liquidity surplus and while it is a welcome thing for both the economy and homebuyers amid the COVID crisis, there is a risk of elevated asset prices feeding into inflation expectations.

Furthermore, headline retail inflation may be showing a decline but core inflation, which strips away the volatile components of food and fuel, remains sticky and elevated, with the latest reading coming in at 5.8%.

The central bank has already shown its intent when it comes to reining in the liquidity surplus by unexpectedly announcing a seven-day variable rate reverse repo operation. In its last policy statement, the RBI announced staggered increases in the quantum of funds to be taken out through variable rate reverse repos.

“The reason why markets did not react to CPI is because the good news has been priced in,” a senior treasury official with a foreign bank said.

“Yes, RBI will be accommodative for some time, but will the repo rate come down? No. And on liquidity, it is certain that they will be very watchful of how much is being infused through OMOs. The market view is that the next round of GSAP will definitely be smaller than Rs 1 lakh crore. The unexpected 7-day reverse repo is a sign that RBI is keeping a very close watch on liquidity,” he said.

Some treasury officials expect that in the next policy statement in October, the RBI will clearly signal its intention to raise the reverse repo rate and perhaps give a roadmap for the same.

“They (the RBI) have said that they will be very transparent. It is possible that they could announce small rounds of increases in the reverse repo rate with a timeline,” the treasury official with the foreign bank said.

Earlier this week, RBI Deputy Governor Michael Patra said the central bank is looking at a glide path when it comes to returning to the 4% target for CPI inflation.

Growth undoubtedly needs to be the biggest priority at the moment, but at a time when major economies are showing signs of tightening monetary policy, the RBI should not find itself cornered if inflation outturns were to throw up unpleasant surprises.

“… A higher policy tolerance of inflation over a longer period suggests risks of delay to our view on policy normalisation, but also implies an increasing risk of monetary policy falling behind the curve,” economists from Nomura wrote.