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FILE PHOTO: One indication of risks embedded in the current accommodative stance is conveyed through the views on economic activity (REUTERS)
FILE PHOTO: One indication of risks embedded in the current accommodative stance is conveyed through the views on economic activity (REUTERS)

Steering liquidity at core of MPC’s balancing act

The current high inflation episode is the result of a once-in-a-century shock

The evolving and expected paths of growth recovery and inflation led the monetary policy panel to unanimously vote to keep the repo rate unchanged, as widely expected. Of greater significance was the also-unanimous voting on continuing with the accommodative stance “as long as necessary—at least through the current financial year and into the next year". This was exactly the language of accommodation in October. Some analysts, including this writer, believed that a slight change in words to signal baby steps towards a normalization well into 2021 might be introduced, but that did not happen. Strong forward guidance obviously remains a pivot for managing market interest rates.

One indication of risks embedded in the current accommodative stance is conveyed through the views on economic activity. FY21 GDP growth forecast was raised from a 9.5% contraction in the October review to a 7.5% contraction (our own forecast is close, at -7.6%). The CPI inflation forecasts were also sharply revised up to 6.8% and 5.8% for Q3 and Q4 FY21 (hence the average of 6.3% for H2) from a range of 4.5-5.4% earlier. This effectively forecloses any room for any further cuts in the repo rate.

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The policy options for the MPC and RBI to manage and accelerate the recovery are a complex balancing of alternatives involving economic and financial trade-offs. Two major issues (among many) arise from the commentary.

First, liquidity management will be the core of this balancing, given the emerging policy “Quadrilemma". There was a slight change in the language on the maintenance of “ample" versus the earlier “comfortable" levels. Despite the oblique deflections in the press conference on management of liquidity, and although initiation of normalization is still distant, a range of tools will certainly be deployed incrementally to gradually drain the system and tighten financial market conditions at short tenors, without disrupting markets.

The second and deeper question is the degree of flexibility enabled in the MPC’s mandate for inflation targeting (IT). Is growth getting overweening importance at the cost of inflation? Is there is a risk of inflation getting embedded back into the system or in consumer expectations, which is any central bank’s nightmare? The IT framework devised in 2016 was meant for normal business cycles with output responses (whether food or non-food) designed to be automatic stabilizers. This current high-inflation episode is, however, the result of a once-in-a-century shock, as the governor has repeatedly emphasized. While inflation does indeed seem to be getting generalized in various categories of the non-food and fuel core inflation, the bulk of the pressures are still emanating from the food component. The dynamics of this persistence due to supply-chain-led disruption is very different from the spirit of concerns in the inflation-targeting framework. The “small window of … for proactive supply chain management strategies to break the inflation spiral" has repeatedly figured in interactions, obviously pointing to the required extra-monetary policy source of the remedy. Both three-month and one year ahead household inflation expectations have also eased modestly. There are certainly emerging risks, with global industrial commodities and oil prices rising, and which are likely to continue for a while with vaccine confidence induced global recovery in 2021. However, the last time India saw persistent surges in inflation was post the 2008 crisis, largely due to the massive pay commission recommended salary increases and then the large MSP hikes. These conditions are currently (and likely to remain) weak, given the significant income and demand destruction.

Finally, encouraging credit offtake continues to be a key objective of policy stimulus. Although no further micro-prudential measures were announced, syncing the ECLGS 2.0 with the previously announced on-tap TLTRO line of 1 trillion, is an attempt to boost loans to small borrowers in an expanded list of stressed sectors. The next review will be informed by the extent and nature of “growth orientation" in the Union Budget. In the interim, the effort will be to further increase credit delivery, while progressively developing financial markets and their oversight, so that India’s economic capacity is positioned to revert to a higher potential growth trajectory.

Saugata Bhattacharya is executive vice-president of business and economic research at Axis Bank. Views expressed are personal.

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