It may be appropriate for RBI to hike the reverse repo rate soon

What are RBI’s reverse repo rate options? (i) Do nothing now and go for a 40bps hike in April; or (ii) effect a 40bps hike; or (iii) go for a 20bps hike now and a 20bps hike in its April policy. Given the current money market rates, we think options (ii) or (iii) make more sense at this moment, but we don’t rule out the possibility of RBI surprising us again by maintaining a status quo, as was the case in its December 2021 policy.

Does it really matter whether RBI hikes the reverse repo rate or not? It has been conducting variable rate reverse repo (VRRR) auctions in multiple tenors (even as short as 2-day) with the cut-off rate at 3.99%, close to the repo rate of 4.0%. While RBI did not hike its reverse repo rate in December, it announced 3-day VRRR auctions on 20 December, which pushed the Mumbai Interbank Offer Rate (Mibor) higher. Between 1 and 20 December, it had averaged 3.50%, which went up to 3.68% between 21 and 31 December and further to 3.72% in January. So all short-term interest rates are higher than the reverse repo rate right now; and with the bulk of the liquidity getting absorbed through VRRR auctions at 3.99%, as per RBI’s intent, the reverse repo rate at 3.35% has become almost irrelevant. Even if RBI keeps it there, short-term interest rates will clear at higher levels, given the ongoing VRRR auctions, as is the case now. So, in that sense, whether RBI hikes the reverse repo rate by 20bp or not will not matter much for markets, except for the fact that it will help this rate realign with other short-term interest rates, and, more importantly, narrow its spread with the repo rate, thus likely reducing volatility in money markets.

Why not hike the reverse repo rate by 40bps in one go in the February policy? If RBI delivers a 40bps reverse repo rate hike in one go this week, then market participants may expect a repo rate lift-off to start from April rather than June. If RBI does not want to give such an impression, then the best course of action will be to hike the reverse repo rate by 20bp now, leaving another 20bps for the April policy, along with a change in stance then.

Why should RBI hike the reverse repo rate by 20bps? It needs to realign this rate with other short-term rates to narrow the LAF corridor and reduce volatility in money markets. For the repo rate to go up by 25bps in June, the formal reverse repo rate adjustment should start now. With the US Fed likely to start hiking rates from March, RBI should start taking small incremental steps toward normalization, in our view. The peak of the third wave is behind us. Mobility indicators having bottomed and are on the rise at this moment. With the economic impact of the third wave likely to be much less than the second, RBI can continue with its normalization process by giving more weight to forward-looking indicators.

Credit growth improved to 9.1% year-on-year (yoy) in December and 8.0% yoy in January, from about 6.0% yoy a few months back, which should be noted.

Consumer price index (CPI) inflation is likely to peak at 6.0% in January and then ease to about 5.5% in April to September 2022, but any shock (related to food, fuel, supply disruptions, monsoon or core prices) could elevate the baseline trajectory. Given this, a strategy of gradual normalization of rates is probably prudent, which may prevent the need for faster adjustment later if an adverse scenario were to become a reality.

If Brent prices stay elevated at close to $90 per barrel, it can push 2022-23’s current account deficit (CAD) to some $105 billion (3% of GDP). While RBI has a sufficient forex reserves buffer, a rising CAD should coincide with a reduction in negative real rates. With the government’s fiscal deficit on the higher side for 2022-23, resulting from a big capex push to support a growth recovery, RBI could consider reversing some of its extraordinary accommodation.

What can RBI do to help the bond market? We think RBI may be compelled to announce an ‘operation twist’ to support the bond market in its quest to preserve an “orderly evolution of the yield curve", but this should coincide with increasing the price of liquidity. RBI will also possibly extend the enhanced held-to-maturity dispensation (limit upped to 22% from 19.5%) by one more year, and include securities to be acquired between April 2022 to March 2023, with limits to be restored to 19.5%, from 22.0%, in a phased manner starting from the quarter ending June 2024.

What revisions are to be expected in RBI’s growth and inflation estimates? We think RBI will refer to the 9.2% yoy advance growth estimate provided by the Central Statistical Office for 2021-22, which would be lower than the central bank’s current projection of 9.5% yoy. We expect RBI to increase its JanuaryMarch CPI forecast to 5.9-6.0%, from the current 5.7%, and also likely revise its April-September CPI forecast upwards to 5.3-5.4% from 5.0% currently.

Kaushik Das is India chief economist, Deutsche Bank