Context
The Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI) on Friday gave a surprise, with a formal start to policy normalisation. This was contrary to the predominant market expectations of a hold.
RBI on the path of policy normalisation
- Focus on target of 4% +/- 2%: While the MPC voted unanimously to remain accommodative, in a change of language, the focus would now be on “withdrawal of accommodation to ensure that (CPI) inflation remains within the target (of 4 per cent +/- 2 per cent) going forward”.
- Remember, the RBI had become a (flexible) inflation-targeting central bank since FY17, whose primary objective is price stability, that is, inflation management.
- The Liquidity Adjustment Facility (LAF) corridor was narrowed back to the conventional 0.25 percentage points from the earlier extraordinary pandemic widening in late March 2020.
- The cap of the erstwhile corridor was the repo rate and the floor was the reverse repo.
- Now, while the repo rate was held at 4.0 per cent and the latter at 3.35 per cent, the floor of the corridor was increased by 0.4 percentage points from 3.35 per cent.
- There was also a change in the monetary policy orientation, of which the stance is one component.
- The priority for monetary policy now is inflation, growth and financial stability, in that order.
Reasons for unexpected tightening of policy
- Inflation concerns: Despite uncertainty over growth impulses and demand concentrated at the upper-income level households, inflation has increasingly emerged as a big concern.
- Given that inflation is likely to average 6.1 per cent in Q4 of FY22, this increases the risk of inflation remaining above the 6 per cent upper target for three consecutive quarters, necessitating an explanation to the government by the MPC.
- One comforting aspect of this scenario is that household inflation expectations remain anchored, with the median of three months to one year ahead expectations (as of March ’22) rising by only 0.1 percentage points from the earlier January readings.
- Stabilisation of demand: On demand conditions, the RBI scaled-down the FY23 real GDP growth projection to 7.2 per cent (from 7.8 per cent), indicating that a combination of continuing supply dislocations, slowing global economy and trade, high prices and financial markets volatility are likely to take a toll.
- One possible reconciliation with modest GDP growth is continuing weakness in services, which is also borne out by channel checks.
- Certainly, continuing high inflation is likely to lead to some demand destruction, which will act as an automatic stabiliser.
- A relatively loose fiscal policy is likely to offset some of this reduced demand, particularly with continuing subsidies to lower-income households.
- Financial stability: This has multiple dimensions – interest and foreign exchange rates, market volatility, banking sector asset stress, and so on.
- An important objective for the RBI is the management of money supply and system liquidity.
- In a rising rate cycle, with a large borrowing programme of the Centre and state governments, interest rates on sovereign bonds are likely to increase without a measure of support from the RBI through Open Market Operations (OMOs).
- This will entail injecting more liquidity into an already large surplus, which might add to inflationary pressures.
- The introduction of the overnight Standing Deposit Facility (SDF) was a significant measure in this context.
- Unlike the reverse repo facility, the RBI will not need to give banks government bonds as collateral against the funds they deposit.
- This is thus a more flexible instrument should a shortage of government bonds in RBI holdings actually transpire under some eventuality, say the need to absorb large capital inflows post a bond index inclusion.
What are the implications?
- Interest rates will begin to increase but, for bank borrowers, this is likely to be a very gradual process.
- For corporates and other wholesale borrowers, who also borrow from bond markets, this increase is likely to be faster as the surplus system liquidity is gradually drained.
- How this is likely to affect demand for credit is uncertain, given the capex push of the government, some revival of private sector investment and likely continuing demand for housing.
Conclusion
This cycle of policy tightening will present a particularly difficult mix of economic and financial trade-offs, but RBI has demonstrated the ability to innovatively use the multiple instruments at its disposal to ensure an orderly transition.
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Back2Basics: Liquidity Adjustment Facility corridor
- Liquidity adjustment facility (LAF) is a monetary policy tool which allows banks to borrow money through repurchase agreements or repos.
- LAF is used to aid banks in adjusting the day to day mismatches in liquidity (frictional liquidity deficit/surplus).
- The liquidity adjustment facility corridor is the excess of repo rate over reverse repo.
