The Reserve Bank of India (RBI) is unlikely to alter its accommodative stance when it reviews monetary policy this week. It is true inflationary pressures are building up, even though relatively benign food prices and a helpful base effect will keep the headline retail inflation numbers at 4-4.5% levels for a few months. However, core inflation, as economists have pointed out, could remain sticky at 5%-plus levels and push inflation up again early next year.
The global backdrop, right now, is very uncertain, even unfriendly with energy shortage—power outages—threatening to further disrupt supply shocks and stoke inflationary pressures. The adjustments to costs everywhere could continue for a while, making it harder to ascertain the inflation trajectory.
At the same time, the economic recovery at home remains largely uneven, masked by the strong profit numbers from the corporate sector. The HSBC recovery tracker, for instance, is just 5% above the February 2020 level. This unevenness will keep the central bank from taking any strong measures to pull out liquidity, and any normalisation of the accommodative policy will be very gradual. Indeed, a hike in the reverse repo rate seems unlikely at this juncture, even though that would have helped ease the volatility in rates at the short-end with some liquidity being drained.
Taking care not to spook the bond markets, the central bank is expected to take a few steps to soak up liquidity, which, at Rs 12 lakh crore, is higher than it was at the same time last year and reaching worrying proportions. Indeed, RBI must start draining some of this liquidity because it is already resulting in risk being mispriced and could create asset bubbles.
To begin with, it may stop adding durable liquidity. There’s a good chance the GSAPs—G-Sec Acquisition Programme—will be altogether discontinued or slowed. This could be adjusted with Operation Twists and more OMOs, which would give the central bank a lot more flexibility. The GSAP was a brave move and probably needed to calm the bond markets, but given the recovery has progressed there is little harm in discontinuing it. Luckily for RBI, the government will borrow Rs 5.03 lakh crore in H2FY22, an amount smaller than expected.
To be sure, RBI has given us some hints it is concerned about the surplus liquidity; the cut-off in the last variable rate reverse repo (VRRR) was 3.99%, a chunky 57 basis points higher than the rate at the previous one. There could be more VRRRs, some of a longer duration. The central bank’s objective, through all the measures, would be to both pull out liquidity and steadily nudge the rates up. It may not state its intentions openly; deputy governor Michael Patra said recently VRRRs should not be seen as a signal either for withdrawal of liquidity or for a rise in interest rates. His point on “tepid and transparent transitions” is well taken. The reverse repo rate will probably be raised in December or early next year from the current 3.35%, which is when the stance could be shifted to neutral.