Time for RBI to clear the air with bond vigilantes
Monetary support is required to recover lost output in next few quarters
As the Reserve Bank of India (RBI) and its monetary policy committee (MPC) gear up for the April policy review, there is palpable tension in the air.
The macroeconomic backdrop has continued to improve, and economic recovery is becoming entrenched. All but a few sectors have breached their pre-covid levels of activity. Gross domestic product (GDP) growth is likely to be around 11% in FY21-22, even with sporadic lockdowns making a comeback. Our estimates suggest that a small partial lockdown is unlikely to make a dent in India’s recovery. Still, this recovery may not be enough. India’s output gap is likely to stay negative well into 2022, and monetary support is required to recover lost output.
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1 min read . 04 Apr 2021Inflation risks appear balanced. Three major risks—rise in manufacturing inflation, higher fuel prices and seasonal pickup in food prices—may keep headline inflation sticky, but it is unlikely to boil over into core inflation materially. Academic research suggests that the impact of higher manufacturing wholesale price index (WPI) inflation on core consumer price index (CPI) is low in an environment of a negative output gap. The rise in energy prices is partly a policy choice, and spillovers from food prices to core CPI have weakened considerably. All considered, we expect both headline and core CPI inflation to remain sticky, but trend lower through 2021, which should give RBI some space to keep policy on hold.
Indeed, our Taylor rule simulations suggest the next repo rate hike should come only in the second quarter of 2022. That means, over the new few quarters, the central bank would be best served by letting the economy “run hot", and recover lost output over the next few quarters. Before actually delivering a repo rate hike, we believe that RBI is also likely to wait for confirmation of the durability of the economic recovery, which is unlikely to be apparent before Q1FY22.
As an interim target, the central bank may well focus on the transmission of past policy rate cuts. So far in the current easing cycle, only ~60% of the rate cuts have been transmitted to the retail deposits, while lending rates are down by only 40% of the policy rate changes since early 2019. We believe transmission still has room to improve, and RBI can play its part by holding steadfast to its commitment to maintain the liquidity surplus and keep policy rates low to allow the prior cuts to fully flow through to lending and deposit rates. Indeed, helped along with a bumped up household savings, conventional and unconventional tools deployed by RBI are starting to yield results, as the flow of funds are now above prior year levels, despite the pandemic.
There has also been a tug of war between ‘bond vigilantes’ and RBI, since the February policy meeting. Despite RBI’s view, yields have risen materially, up 50-75 basis points across the curve, keeping it very steep, and RBI recently noted that the rise in yields could undermine the nascent recovery and once again reiterated its commitment to keep yields in check. The latest MPC will be meeting with the disconnect between current market pricing and RBI’s policy preferences widening.
Communicating an eventual exit from its extraordinarily accommodative policy was always going to be a challenging exercise for the central bank. Through a steep yield curve, the market is signalling that the risks of a misstep are high. Still, RBI has rightly begun the process, by adjusting the level of liquidity, and normalizing the cash reserve ratio (CRR).
The next step in this process should be a shift to “state-specific forward guidance" to pave the way for the withdrawal of the extraordinary accommodation. This would be followed by a normalization of the liquidity adjustment facility (LAF) corridor by raising the reverse repo rate, setting the stage for an eventual repo rate hike in Q2FY22. Still, the upcoming April monetary policy meeting presents RBI with an opportunity to bridge the communication gap and convince market participants of its intent by both talking and walking its intended path.
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Rahul Bajoria is chief India economist at Barclays.
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