Make haste slowly: Inflation is a concern, but growth worries require adequate liquidity
The significant shift in the Monetary Policy Committee (MPC) stance on Friday, to a less dovish stance and prioritizing inflationary concerns over growth, was entirely justified. The fact that the price of the Standing Deposit Facility (SDF), now the effective floor of the Liquidity Adjustment Facility (LAF) corridor, at 3.75% was a bit higher than what the markets had negotiated suggests that RBI is seriously concerned about the impact of the Russian-Ukrainian conflict. Certainly, a 60 basis point reduction in GDP growth, to 7.2%, for FY23 is very worrying.
But the central bank’s inflation forecast of 5.7% for this year is rather optimistic, even though it represents a 120 basis point increase from the previous forecast, and looks more like an interim assessment than a a final assessment of the price pressures building up in the economy. . On the one hand, there is uncertainty over crude oil prices, which sit above $100 a barrel, as well as a host of other commodities, including edible oil. Again, core inflation is expected to exceed 6% as manufacturers pass on higher input costs to consumers.
Thus, the inflation forecast would likely be raised very soon, followed by a change in monetary stance to neutral. Indeed, the RBI has clearly signaled that the rate cycle is turning, although it has hinted that it has some tools that would help it see through the government’s borrowing programme. This means that the benchmark yield can gradually reach levels of 7.4% over the next six months; they closed at 7.12% on Friday. The central bank now seems reconciled to a gradual rise in yields, although it would try to keep the curve flat by letting short-term rates rise. Moreover, even if the repo rate hikes are launched in June or August, as expected, RBI will likely stagger the increases. The thing is, it should support growth and will likely focus much more on cash management.
RBI opted to continue the normalization process by narrowing the LAF corridor to 25 basis points using the overnight SDF at 3.75%, which is well over 40 basis points above the fixed repo rate 3.35%. Using the SDF as the policy rate to absorb liquidity is a good move, as it would remove the need for collateral. Previously, the central bank absorbed excess liquidity through VRRRs. Additionally, as the government’s borrowing plan unfolds, bond markets will be looking for open market operations that RBI could conduct. This will help banks now be able to store more bonds in the held-to-maturity category with a higher cap of 23%.
Indeed, it would be essential to manage sustainable liquidity and maintain financial stability as the system moves from a surplus of 8.5 trillion rupees to a surplus of probably 2-2.5 trillion rupees. The central bank reassured markets that the withdrawal would take place on a “multi-year” schedule. The fact that there has been a sharp 60 basis point downward revision to GDP growth forecasts is proof that the economy needs support. RBI acknowledges that consumer demand remains below pre-pandemic levels and that weaker external demand could tarnish exports. Rural demand has been very weak and may not recover significantly even after a bumper rabi harvest, as terms of trade for agriculture may be adverse with soaring input costs. As such, the liquidity in the system should remain sufficient so that lending rates do not soar. This could then hamper credit demand and harm the recovery.