The Reserve Bank of India (RBI) appears to be conditioning the markets for an eventual normalisation even as it draws an insular approach, contrasting the rising evidence of normalisation across major central banks.
We think it is only a transient differentiation and we expect the RBI to adopt a more overt articulation after the US Fed embarks upon quantitative easing (QE) taper in November 2021.
Expecting core inflation to gain momentum on the back of elevated Wholesale Price Index (WPI) inflation and narrowing demand gap, we see a reasonable chance of the RBI also hiking rates in 2022.
The RBI’s status quo on key policy rates (repo rate at 4 percent and reverse repo rate at 3.35 percent) and accommodative stance was not surprising. But there are some calibrations that foretell the onset of policy normalisation.
Among the key points that embody these changes are the decision to not announce further purchase of G-Securities under RBI’s G-SAP (Government Securities Acquisition Programme). If indeed this marks an end of the G-SAP purchases, India’s version of QE may have ended.
The probability is high, given that the RBI now considers such an intervention has outlived its relevance.
The second point is that the RBI also announced a larger 14-day variable reverse repo fortnightly auctions, starting from today, rising from Rs 4 lakh crore to Rs 6 lakh crore in the first week of December.
This would imply a lower proportion of overnight liquidity from the current 45-50 percent of surplus liquidity under RBI’s LAF (liquidity adjustment facility) window. The 14-day repo can also be complemented by 28-day auctions.
The RBI has been careful in mentioning that these changes do not mean a change in policy stance. However, given that it has been stated in the context of the fading COVID-19 impact, and the near-consensus view favouring normalisation, it will be fair to assume that the RBI has adopted gradual normalisation.
Excess liquidity in the form of reverse repo balance (including overnight rate at 3.35 percent and 14-day variable reverse repo at 3.6 percent) currently stands at Rs 9 lakh crore or 6 percent of bank deposits and the potential liquidity overhang is Rs 13 lakh crore or 8.3 percent of bank deposits. These levels are several times higher than the desirable level of 0.5 percent under normal conditions.
We believe that the deluge of surplus liquidity has been creating distortions in the interest rate vector and asset price valuations. Very low money market rates are also cannibalising credit growth in the Indian banking system. The current liquidity surplus goes far beyond what may be needed in the context of the prevailing sub-potential demand situation in India.
The RBI has also made a distinction between the trends of policy normalisation in several countries (notably in advanced economies) that are facing high inflation and better than pre-COVID demand conditions, and those that are steadfast on an accommodative stance in response to the weaker economic situations.
India appears to have been characterised in the second category, given that Q1FY22 real GDP was 9.2 percent below the pre-COVID level and headline inflation projection for FY22 has been scaled down to 5.3 percent in response to softening food inflation.
Thus, India’s gradual normalisation plan is pivoted on the prevailing negative output gap and marginal risk of an inflation overshoot. India’s real GDP growth projection for FY22 is maintained at 9.5 percent, with an exit rate of 6.1 percent. The exit rate of headline CPI inflation is projected at 5.8 percent.
In our view, the RBI’s ability to sustain an insular monetary policy path can get diluted, going forward, as the US Fed embarks upon a six-month QE tapering beginning November 2021 and the eventual rate lift-off in 2022.
A strong dollar and improvement in domestic credit demand should narrow excess liquidity, thereby strengthening the articulation towards policy normalisation by the RBI as well.
The RBI will also need to contend with the prospects of higher core inflation. Currently, the RBI’s comfort on headline inflation emanates from easing food inflation, which is a fair outcome, given the abundant domestic food supplies and declining global food prices from the recent peaks. But the pipeline impact of high WPI inflation and narrowing of the demand gap should push up core inflation, going forward.
Even during depressed times, core inflation averaged at 5.3 percent in Q1-Q3FY21. It moved higher at 6 percent in 2021 YTD (Jan-Aug’21) when pricing power in the manufacturing sector was still weak. As demand conditions improve, the pipeline inflation will start shoring up core inflation above 6.5 percent in our view.
Thus there is a distinct possibility of policy normalisations in 2022, lower excess liquidity, and rate hikes, in our view.
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