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India’s central bank has taken 100 measures to blunt the impact of the pandemic on the economy over the past 18 months without breaking a sweat. While some of these have been reversed, the big ones on liquidity and policy rates are yet to be touched. The tentative walk towards this reversal seems to be unsettling for the Reserve Bank of India (RBI).

Last week, when the RBI’s six-member monetary policy committee (MPC) met for the 10th time since the pandemic began, the first sign of discomfort was visible with one dissent on the policy stance. Beyond that, too, the central bank’s worry came through when governor Shaktikanta Das took pains to state that the hike in the size of variable reverse repo rate auctions should not be construed as a reversal of stance. Needless to say, markets and analysts took it exactly as a sign of reversal.

“While policy normalization (shift to a neutral stance and/or reverse repo rate hikes) is likely to begin in late FY22, the move towards liquidity surplus recalibration, as we have been expecting, has already begun," analysts at UBS wrote in a note.

Unsavoury combination
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Unsavoury combination

But what makes RBI so uncomfortable to go on reverse gear apart from the unsavoury impact it may have on markets?

One reason could be that the economy has become hard to read. Blame it on the pandemic for making everything difficult to assess. From economic data to sentiment surveys, there is little cohesion to indicate even a tentative trend towards either normalcy or more pain.

For example, the central bank’s survey on consumer confidence shows Indians are optimistic about prospects one year ahead, but its household inflation expectations survey shows more people expect prices to increase faster. This renders the outlook on consumption ambiguous as price pressures tend to dampen consumption, but hopes of better income could induce spending. As such, some consumption trends may have altered irrevocably in the wake of the pandemic. This ambiguity can be stretched to most parts of the economy. Add in the potential threat of another wave.

But dealing with ambiguous and sometimes sub-optimal data is not new for RBI. In fact, a central bank can prove itself only by giving clarity during uncertain times.

To its credit, the central bank has given clarity over why it believes growth recovery is hesitant and inflation transitory. Its move to hike inflation forecast is more mechanical than a signalling one. Michael Patra, deputy governor in charge of monetary policy, explained that without the base effect noise, the recovery isn’t encouraging. When the inputs for policymaking show an uncertain trend, what happens to predicting policy outcomes? Interestingly, most economists conclude that the first of the rate hikes, a move on the reverse repo rate, would begin by early next year despite RBI giving no indication on this.

Fixed income markets have already begun to price in expectations. “There seems to be an extreme conviction that significant normalization is coming sooner rather than later, despite what the RBI/MPC is saying," wrote Suyash Choudhary, head of fixed income at IDFC Mutual Fund.

That said, there is variance among economists on whether RBI is playing with fire when it comes to inflation. Economists at the country’s largest lender, State Bank of India, warn that RBI may be erring in its assessment of inflation as transitory.

“Even though RBI has clearly emphasized the inflation trajectory in an upward direction to be transitory, we believe inflation management could pose a serious challenge when the elevated fuel price pass-through starts to occur and, thus, inflation shock is unlikely to be transitory even by definition," said an SBI research note. Those at HSBC term inflation as a chameleon as the underlying drivers have been changing frequently. “It (monetary policy) is a countercyclical tool and can help close the output gap, but not drive potential growth," a note from them said.

On the other hand, Indranil Pan, chief economist at Yes Bank, believes RBI won’t move on either liquidity or rates until the end of FY22. Choudhary of IDFC MF explains in his note that a lower level of aggregate demand and supply may be the reason behind the reluctance of RBI to indicate a reversal. It remains to be seen whether inflation is becoming enduring or unseen disinflationary pressures are at play. Either way, RBI would be ill at ease to throttle back its accommodation before the clouds clear over the economy.

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