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RBI faced with managing an impossible trinity


Going into the December monetary policy, markets were enveloped with a degree of nervousness given concerns around sharp fall in short-term rates, elevated inflation prints and better than expected growth normalization momentum.

Under the leadership of Governor Shaktikanta Das, Reserve Bank of India’s monetary policy committee (MPC) yet again proved its mettle of not only navigating a quagmire with elegance, but carrying an uphill task of soothing market nerves. The policy re-instated that the central bank will continue to preserve financial market stability, ensure smooth functioning of all market segments and ease financial conditions by maintaining adequate liquidity. At the same time, RBI raised its inflation forecast and growth outlook, without rocking the boat.

Inflation vs growth
Inflation is now increasingly taking centerstage. As the growth momentum picks up pace, there could be a shift from supply side disruptions to more demand side pressures on inflation. Higher input cost pressures might translate into output prices, leading to stickiness in overall inflation. These concerns are leading to our inflation trajectory being slightly higher than MPC’s by ~50 bps for H1FY22, while remaining similar to the now upward revised forecasts of inflation for H2FY21 averaging ~6.2% YoY (vs MPC’s at 6.3% YoY).

While our internal forecasts are slightly more positive on growth (lower contraction of ~6% YoY), we do think that the positive momentum through high frequency indicators, encouraging news on vaccine development and higher expected fiscal support, is leading to a subtle shift in MPC’s rhetoric from growth to inflation.

Liquidity concerns
Concerns on early unwinding of easy monetary conditions and absorption of excessive liquidity were put at bay for the time being, with Das stating that various instruments would be used to ensure “ample liquidity is available to the system.” This has led to a relief rally in the short end. Refraining from announcing any liquidity absorption measures during the policy was a well thought out measure, and once again signifies RBI’s understanding of market workings and idiosyncrasies. Any such announcement could have led to a sell-off, and in part negated the achievements on lowering yields, keeping cost of borrowing low as well as questioned the credibility of the central bank (given the messaging and guidance in the October policy). Having said that, the current market imbalances of short-term rates moving away from the anchor policy rates needs to be corrected to avoid further distortions.

Das mentioned that excess foreign capital flow is also leading to the surge in liquidity, which the RBI is trying to manage by sterilisation through reverse repo. In our view, this deluge of funds could possibly continue. While the governor and deputy governor alluded to markets finding their own balance, we do think that going ahead, the RBI could resort to announcement of long-term reverse repo or MSS or SDF window, in calibrated steps to ensure sterilisation of liquidity in a non-disruptive manner.

Overall, the RBI is faced with a herculean task of managing the impossible trinity of inundation of inflows, managing exchange rates in line with macro fundamentals and the ongoing high inflation. Though the excess liquidity would not impact inflation, return in demand could reverse this trend and would be something that would play out in the minds of the policy makers going ahead.

Given this backdrop, our official rate call is now moved to a long pause from expectations of a rate cut in April. This is based on concerns over:

1) Upward revision of inflation trajectory by more than 100 bps

2) Elevated inflation prints, including broad-based food inflation and sticky core inflation

3) Guidance on monitoring of threats to price stability and commitment to inflation targeting

4) Upward revision of growth forecasts

Markets will now look forward to the MPC minutes which could throw more light on discussions around the evolving dynamics of inflation as well as structure of the yield curve. Moreover, return of reflation trade in the US, construct of next years’ budget and borrowing program could increasingly start taking centerstage. Given these concerns, we expect range trading in the 10-year benchmark with the threshold of ~5.75 per cent on the lower end. On USDINR, we think that the RBI would prevent any undue appreciation of the currency and given the elevated REER, would continue intervening in the forex market, allowing the currency to operate within the range of 73-75.

(The author is Head, Global Markets, ICICI Bank. Views are personal)

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