Without large enough stimulus from Centre, there’s only so much RBI can do to stimulate GDP

Given headline retail inflation remained elevated—at 6.7% in August—RBI is unlikely to lower the key repo rate this Friday. The status quo will not disappoint banks given they have surplus funds—deposits are growing at a smart 11-12% well above loan rates of 6-7%. From RBI’s point of view, not all the 250 basis points of repo cuts since February 2019, have been fully transmitted, but it would not want to lose out on the gains. To that extent, it would endeavour to reassure the bond markets that it will keep liquidity abundant. The tone of RBI’s statement will probably be soft, and the stance should stay accommodative as it hints at rate cuts later in the year. Indeed, going by the work of at least two of the three new members of the Monetary Policy Committee (MPC), the MPC, economists believe, will acquire a dovish tilt.

To be sure, the MPC will express its concerns on inflation, as it did in August when it said it would wait for a “durable reduction” before it resumes the rate cuts. The concerns are not unwarranted since inflation has been overshooting the inflation target. While the rise in prices may have moderated in July and August, supply-side pressures on prices persist. Inflation is expected to peak at around 6.8% in Q3FY21 before easing over the next 6-12 months, due to favourable base effects, good rains, lower imported inflation and easing supply constraints, hovering around 4.5% for most of 2021. It would be important to get RBI’s detailed projections for both growth and inflation since that would help the markets assess the central bank’s stance.

While the economy is recovering faster than anticipated post a 23.9% contraction in Q1, it is not clear whether the pick-up in demand is due to pent-up demand getting satiated or whether demand is becoming more formalised because the informal economy isn’t able to get back on track fast enough. It would be helpful to hear out RBI on the growth trajectory because if the recovery isn’t sustainable, the pressure on prices—especially core inflation—would be that much lower.

However, notwithstanding the relatively strong high-frequency indicators, the corporate sector remains over-leveraged and strapped for cash which, in turn, would cap remuneration and recruitment. The economy is set to contract by 10-11% in 2020-21. Indeed, until there is certainty on a cure, it will continue to remain sluggish, especially since there are no signs that the government is going to provide any big fiscal stimulus. That makes it onerous for the central bank, which must try and frame policy based on where it sees inflation a year ahead, ignoring some of the near-term rise in prices. Indeed, as many have pointed out, the entire concept of flexible inflation targeting needs to be revisited and perhaps replaced by a more suitable policy framework. The fact is RBI is struggling to rein in yields, and four out of the last seven auctions have either partly or fully devolved on the underwriters. The benchmark yield is hovering around 6%—even though there is surplus liquidity—with the market fearful of a large supply of paper from state governments, which could be as high as `4 lakh crore in Q4FY21. RBI needs a lot more flexibility to manage the financial markets in these difficult times.