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Against the backdrop of emerging stagflationary pressures, monetary policy across the world is standing at an important crossroad—when to start normalization and at what pace to proceed? The issues would be similar for the Reserve Bank of India’s monetary policy committee (MPC) when it meets for the October policy, and there are no easy answers.

The developments on the growth front have been mixed. On the positive side, the MPC is likely to draw comfort from the fact that monthly activity data at an aggregated form has now almost returned to the pre-covid level. Virus and vaccination trends are also indicating a lower risk of economic disruption from any possible third wave. However, recent developments in China might have real economy contagion on global growth and in turn pose some risks to India’s burgeoning exports—an engine of growth that was nicely revving. Moreover, our Breadth of Recovery indicator suggests that almost 30% of the high-frequency activity variables are yet to come close to their pre-covid levels, emphasizing the view of an uneven recovery requiring policy support.

On the inflation front, the next three months could witness below 5% CPI, creating a very favourable backdrop for monetary policy normalization and prompt the MPC to lower its own FY22 inflation forecast (5.7%) by 40-50bps. The MPC’s stance of a supply side-led transitory increase in inflation during May-June has been vindicated. However, elevated inflation expectations and sticky core would remain areas of concern, especially when there is a renewed surge in global commodity prices.

Normalization of global supply situation for different factors and commodities is taking longer than expected and the whiplash effect could keep prices elevated despite an incomplete demand recovery with uncertain pass-through for Indian inflation. We had highlighted an additional risk of rising vegetable prices due to unseasonal rains and it will be interesting to see whether RBI bakes these upside risk possibilities into its forecasts or not.

Given this macro backdrop, there is some merit in considering a 15bps reverse repo hike now because of two reasons—one fundamental and one technical. We have to appreciate that RBI took two exceptional emergency measures during the first wave—widening the repo and reverse repo rate corridor to 65bps from the normal 25bps and pushing the effective overnight rate closer to the reverse repo rate rather than the repo rate as mandated by the monetary policy framework. The economy still needs policy support, but is not any more in an emergency situation. So, the process of withdrawing the two emergency measures can be started now in a finely calibrated way.

The technical factor is the avoidable risk of highly volatile short end rates when the corridor is so wide, and RBI is conducting very large variable rate reverse repo (VRRR) auctions every week. Earlier, the VRRR cut-off yields were in the 3.4-3.5% range, but in the recent auctions, they have been more elevated and volatile. It is probably not a desirable outcome of monetary policy to have such fluctuating short-term rates. Gradual narrowing of the corridor would be able to achieve that. Also, since the VRRR cut-offs have drifted higher to the middle of the corridor, any small reverse repo hike at this moment is unlikely to have a material impact on the overall interest rate structure.

On managing the quantum of liquidity, there is a modest chance that the VRRR programme could be expanded to include tenors beyond 14 days. The slightly altered monetary policy stance would also be reflected in the need for tapering off the additions to the banking system surplus liquidity by lowering the Government Securities Acquisition Programme target for the third quarter to 50,000 crore or so, and retain the operational flexibility of doing open market operations if necessary. In fact, liquidity concerns could force RBI to neutralize G-SAP liquidity with Operation Twist, especially at a time of large capital inflow.

However, the MPC will also have to make a distinction between these “operational" changes and the core thrust of monetary policy. Highlighting soft and uneven recovery and the emerging global growth risks, the MPC could reiterate its bias of supporting growth through an extended period of accommodative monetary policy. Communicating this nuanced difference between normalizing “operations" versus keeping the policy stance intact could be a critical challenge. Though, in our view, a relatively benign macro backdrop with the bulk of government borrowing behind us could be the appropriate time to attempt it.

Samiran Chakraborty is chief economist, India at Citibank.

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