The status quo on monetary policy is likely amid recent uncertainty

Photo: Mint
Photo: Mint

Summary

Emergent risks would argue for a stance change but RBI’s dovish disposition will probably prevail in its April policy review

It is widely anticipated that the Reserve Bank of India’s (RBI) monetary policy stance and reverse repo rate will remain unchanged after the Monetary Policy Committee (MPC) meeting that is underway. However, based on macro-economic and geopolitical developments since the last monetary policy meeting on 10 February, we think the MPC should change the policy stance to neutral from accommodative on 8 April and raise the reverse repo rate by 40 basis points (bps) as well. Given the dovish disposition of the committee, though, it is more likely that status quo will be maintained again on both. If the stance is changed along with an increase in the reverse repo rate, in the backdrop of significantly higher inflation risks, we will welcome it. But we think the MPC will highlight downside risks to growth arising from elevated oil prices, on account of the Russia-Ukraine conflict, and argue that it is better to stay on the sidelines, given the heightened uncertainty at this stage. If the MPC/RBI somehow decides to change stance and/or hike the reverse repo rate, it will come as a surprise to many, given what was seen in the past few policy reviews, and with the global macro backdrop so fluid and uncertain, it’s unclear if RBI would want to surprise market participants.

Forward guidance could hint at a change of stance in the June policy: The April policy could yet see a subtle shift in guidance, preparing markets for a potential change of stance to neutral in the June policy meeting. Governor Shaktikanta Das has said in the past that RBI does not want to surprise the market and that “the central bank’s actions will be calibrated and well telegraphed"; therefore, in our view, the April policy statement could be used as a tool to guide market participants accordingly.

The reverse repo has become almost meaningless, but RBI may consider raising it in the June policy, together with a change in stance: With most short-term rates clearing closer to the repo rate of 4.0%, the reverse repo rate at 3.35% has almost lost its relevance. Indeed, RBI has also started referring to the “effective reverse repo rate", which is clearing close to the repo rate of 4.0%. But as long as the reverse repo exists, the central bank will have to raise it by 40bps (a basis point is a hundredth of a percentage point), so as to narrow the gap with the repo rate to the pre-pandemic level of 25bps. With Governor Das linking the likelihood of changing the reverse repo rate with that of a change in policy stance, it is plausible that the adjustment will happen from the June policy onwards.

A repo rate lift-off may start from August with hikes of 50bps expected in 2022: If the monetary policy stance changes to neutral in June, then a repo rate lift-off may take place from August. We still expect 50bps (0.5% that is) of repo rate hikes in 2022, with a 25bps hike pencilled in for the third quarter of 2022 and another for the fourth quarter. Even if the repo rate rises to 4.50% by end-December 2022, real interest rates will stay negative to the tune of 130bps, as we expect consumer price index (CPI) inflation to average 5.8% in 2022. RBI is unlikely to respond with larger and faster rate hikes just because of an aggressive US Fed rate-hike cycle.

RBI is likely to use $95 per barrel as its oil price assumption for the first half of 2022-23: Given the significant volatility in global oil prices, it will be extremely difficult for RBI to make a firm oil price assumption for the next six months, but we think it will likely assume $95 per barrel for the first half of the current fiscal year, which will be $20 higher than what the October 2021 policy report assumed.

RBI is likely to hike its CPI forecast for 2022-23 by 100bps to 5.50%, but not beyond that: We expect RBI to revise up its retail inflation forecast for this fiscal year from the current 4.5% average, but the central bank is unlikely to raise it beyond 5.50%, in our view. Our own CPI inflation forecast for 2021-22, 2022-23 and 2023-24 is at 5.5%. We expect the MPC to highlight current inflationary pressures as offshoots of supply-side and cost-push factors and argue that monetary policy tightening may not be appropriate at this stage, as this could lead to a larger-than-warranted growth sacrifice. However, as per our own assessment, we remain worried about India’s inflation dynamic, as we see clear evidence of persistence and generalization in price data that may prevent the inflation expectations of households from returning to pre-pandemic levels.

RBI is likely to lower its 2022-23 real GDP growth forecast to 7.5% from 7.8% on account of the adverse impact of higher oil prices: With prices of Brent crude oil hovering above $100 per barrel, coupled with risks of a slowdown in China due to covid and potentially aggressive rate hikes by the US Fed that are likely to result in a global economic slowdown, RBI will likely lower its forecast for real 2022-23 gross domestic product (GDP) growth in its April policy from its current projection of 7.8%, but we don’t expect it to be cut below 7.5% at this stage;

The terminal repo rate should be around 5.50% in this cycle, though the Taylor Rule formula suggests higher levels: Based on growth and inflation projections for 2022-23 and beyond, a simple Taylor Rule application indicates a terminal repo rate of 6.00% or higher, but given RBI’s dovish disposition, we expect the terminal repo rate to rise at most to 5.50% in this cycle. As India’s output gap closes this fiscal year and CPI inflation averages 5.5% over the next 12-24 months, the repo rate should rise to at least 5.50% for non-negative real interest rates.

RBI is likely to support the government’s borrowing programme by buying bonds, but likely through OMOs and an OT rather than GSAP: We expect RBI to continue supporting “an orderly evolution of the yield curve", by bond purchases through open market operations (OMOs) and an ‘operation twist’ (OT) in the fiscal year’s first half, but any type of a government securities acquisition programme (GSAP) is unlikely, given that RBI is in liquidity-absorption mode through its multiple-tenor variable rate reverse repo (VRRR) auctions. However, with India’s current account deficit likely to widen closer to $100 billion (or 2.7% of GDP) in 2022-23, leading to a balance-of-payments deficit, RBI could argue in favour of domestic bond purchases to support the necessary reserve money creation each year (from a flow perspective), while dealing with the stock of surplus liquidity separately through VRRR auctions and other tools. RBI may also possibly extend the enhanced held-to-maturity (HTM) dispensation (limit upped to 22% from 19.5%) by another year to include securities to be acquired between April 2022 and March 2023.

Kaushik Das is managing director and India chief economist, Deutsche Bank AG

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