By Suvodeep Rakshit
Globally, the monetary policy tide has turned sharply over the last few weeks with larger DM central banks making their intent (and actions) clearer. On the domestic front, the economy continues to recover and the impact from the Omicron variant is muted. The Union Budget targeted a large fiscal borrowing which has shifted long-end yields higher. Even as the RBI may want to be cautious and gradual in its policy normalization, reversing some of the pandemic related measures will need to start. We believe that the RBI should start normalizing the reverse repo rate by raising it 20 bps in the February policy.
The RBI MPC is likely to continue highlighting its concerns on inflation with crude prices and commodity prices remaining elevated. However, the committee is unlikely to change its stance or signal an immediate hike in repo rate. But as in the earlier meetings, it will likely indicate its comfort in liquidity (and the cost of liquidity) normalization which lies in the RBI’s purview. A smaller corridor between the repo rate and reverse repo rate could help in reducing the volatility too. Importantly, it will also explicitly signal the start to normalization of pandemic measures.
Inflation is likely to remain elevated between 5.5-6% over the next few months and drift lower closer to 4.5-5% through most of CY2022. However, the risks of crude prices remaining elevated along with pass-through to higher pump prices will keep fuel price inflation risks alive. Upside risks from global commodities into producer prices and pass-through to retail prices will also weigh on inflation for most part of the year. The MPC will remain concerned about inflation, especially as the growth momentum continues to improve, especially in the contact-based services sectors. One of the main worries will be core inflation continuing to remain elevated in the range of 5.5-6% for most part of the year.
Growth impulses softened after the festive season but have been relatively less affected due to the third Covid wave. With cases coming down significantly and vaccinations progressing at a rapid pace, growth momentum is likely to remain positive. However, the RBI is likely to remain cautious on the growth trajectory. The unorganized economy has been affected much adversely than the rest of the economy and will continue to require some support. Also, from a liquidity perspective, the RBI will need to be nimble on the calibration, especially once credit growth picks up.
Government borrowing risks being much larger than it has been over the next few years. With a large adverse skew between the demand and supply of market borrowings, it will require some help from the RBI—as has been the case over the last couple of years. However, as the RBI focuses on normalization it will be difficult to keep managing yields. Bond yields are already pricing in most of these factors though upside remains. RBI may have some opportunity in case of FX outflows and consequent intervention to keep a check on any sharp INR depreciation. This could open up some space for supporting yields.
Overall, the RBI needs to return to ‘normal’ monetary and liquidity policy. This will enable the RBI to retain the flexibility to calibrate as and when required along with, possibly, a better handle on the yield curve. In the February policy, even as the RBI MPC maintains the accommodative stance and keeps the repo rate unchanged, the RBI should hike the reverse repo rate by 20 bps. This will push up the floor on the front-end of the curve and start off on the normalization without significant adverse impact on the economy.
(Suvodeep Rakshit is Senior Economist in Kotak Institutional Equities. Views expressed are the author’s own.)
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