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A near consensus is emerging on the expectations about the October Monetary Policy Committee (MPC) meeting—a pause in rate cuts, but continuation of the ‘accommodative’ policy stance. Our expectations are not different from the consensus and, hence, a more interesting discussion would be to look beyond the October policy into what role monetary policy can play in countering India’s different macro challenges over the rest of the year. This issue is also relevant because the MPC has just got three new members and they might have substantially different views on these matters.

In the October policy, the Reserve Bank of India (RBI) is likely to provide its first quantitative assessment of the damage to growth in FY21. There are likely to be two opposing considerations from the growth angle. One, the extent of monetary stimulus that would have probably been justified in the early part of the lockdown to stabilize things, would need to be tapered down gradually as activity levels are back up to 85-90% of pre-covid levels and expected to improve further. On the other hand, there is certainly a permanent damage to the demand side that would necessitate monetary policy to remain supportive for a longish period. We think in the October policy, the focus will remain on the latter objective, but some signs of normalization of policy might already be at play, as we discuss below.

However, unfortunately, a stubbornly high headline CPI, averaging 6.6% over the past 10 months, is posing a challenge to the MPC’s primary mandate. There is at least one more elevated September CPI print on the back of spiking vegetable and protein prices before the favourable base effect starts to drag it down. Also, if one really dissects the rising core inflation trends, then only three components with double-digit inflation are causing the damage—gold prices, excise duty-led fuel prices and VAT-led beverage prices. Other items in core inflation are not showing much demand side pressures, indicating the rather limited role of monetary policy in taming inflation now.

Much of the market reaction to the October policy would depend upon whether the MPC takes such a granular view on inflation or opts for a more conservative stance of worrying about the impact of the sustained elevated CPI on inflation expectations. This will determine whether there is any further scope of rate cuts in this cycle. In our view, the earliest rate cut considerations could be in the February policy.

It is also important to understand the MPC’s perception about the role of large banking system surplus liquidity in causing either inflationary pressures or asset price distortions. While the RBI would want to keep interest rates low and avoid any undue exchange rate appreciation, these two objectives would be difficult to achieve if the RBI simultaneously wants to taper the large liquidity surplus too. Several actions of the RBI over the past month or so seem to suggest that the preferred options to put a lid on long-end yields creeping up have been of the liquidity-neutral variety (Operation Twist, HTM relaxation for bank buying of government bonds, yield signals through active management of bond auctions, etc.). These measures have broadly stabilized the interest rate markets for now because the financial system remains highly repressed with no appetite for extending private credit. However, finding effective incremental liquidity-neutral instruments might be difficult as the bond markets are staring at an oversized second-half borrowing calendar for the central and state governments.

In an extremely fluid situation, guiding the markets on how the RBI is planning to navigate through the policy conundrums is a challenging task. The October policy could become a critical one in shaping market expectations if the RBI is able to provide some comfort on the larger game plan to manage the elevated term premium while keeping the policy rate on hold for now.

Samiran Chakraborty is managing director and chief economist, India for Citigroup.

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