RBI holds steady as it sides more with growth recovery than with its inflation objective – The Financial Express

Clipped from: https://www.financialexpress.com/opinion/rbi-holds-steady-as-it-sides-more-with-growth-recovery-than-with-its-inflation-objective/2143694/

Despite raising its inflation forecast, RBI did not take immediate steps to reign in surplus liquidity, thereby choosing economic recovery over inflation control, at least for now.

By Pranjul Bhandari & Aayushi Chaudhary

The RBI policy was in line with our expectations on many fronts. One, it kept policy rates unchanged (repo rate at 4%, reverse repo rate at 3.35%), and stance accommodative “as long as necessary—at least during the current financial year and into the next financial year—to revive growth on a durable basis”. Both decisions were unanimous across the six MPC members.

Two, it raised its inflation forecast sharply, from 5% in H2FY21 to 6.3% (6.8% in 3Q and 5.8% in Q4), highlighting that the outlook has turned “adverse” relative to two months ago. While it did mention that cereal and vegetable inflation could ease, it highlighted that other food items might remain inflationary for longer. It expressed worries on rising oil prices and cost-push pressures feeding core inflation. We have been warning that inflation will remain higher for longer, led in part by the disruption in India’s informal sector, which makes up half of the economy.

Three, it raised its growth forecast as well, from a contraction of 9.5% in FY21 to a contraction of 7.5%. Interestingly, it now expects growth to be positive in the last two quarters of the fiscal year (+0.1% and +0.7% respectively).
RBI has been juggling competing objectives on inflation, bond yields and the rupee at a time when public borrowing is high, and unconventional policies abroad are resulting in elevated inflows into the Indian economy. If it buys government bonds or dollars to keep bond yields from rising or the rupee appreciating in the midst of a growth crisis, it will only add to elevated domestic liquidity, stoking inflation worries further.

Markets were looking carefully at today’s policy to get a sense of where the balance across objectives will lie. And RBI made it all too clear, at least for now.

On the one hand, it raised its inflation forecast, even calling its evolution “adverse”. But, on the other hand, it did not proactively announce any measures to drain liquidity or bring short-end rates back into the LAF corridor. As is well known, short-end money market and T-bill rates have fallen well below the reverse repo rate in recent weeks.

RBI stated categorically that “the various instruments at our command will be used at the appropriate time, calibrating them to ensure that ample liquidity is available to the system … our paramount objective is to support growth while ensuring that financial stability is maintained and preserved at all times”.

As such, we believe it sided more with growth recovery than with its inflation objective (of 4%, with a 2-6% tolerance band). This choice in our view was led by (1) a large government borrowing schedule for the year, which will need RBI OMO purchases and flush liquidity in order to be non-disruptive for bond markets, and (2) still weak growth, despite the upward revision in the forecast, which may need handholding for longer. Indeed, as we have explained before, the official GDP estimates may be overstating the real growth on the ground, as they don’t account for the informal sector appropriately

And yet, policy priorities could change next year. With the coming of a vaccine, rising recovery rate and herd immunity in some parts of the economy, activity could get a boost, particularly in the services sector, thereby driving up service inflation. And, we believe RBI may not be able to ignore that in the face of rising economic growth.

We believe that RBI will steer on a normalisation path in H1FY21, using a host of instruments, ranging from wider participation of entities in the reverse repo window, holding variable reverse repo auctions at higher rates, setting up a much-discussed SDF window to absorb surplus liquidity, raising the CRR rate back up, and not replenishing the currency in circulation leakage. In fact, the use of various instruments may be necessary in the face of the impossible trinity which RBI is facing.

We want to emphasise here that there is a lot RBI can do in the normalisation process, without embarking on a rate hiking cycle.

Co-authored with Priya Mehrishi, Economics Associate, HSBC Global Research
Edited excerpts from HSBC Global Research’s India’s RBI holds steady (dated December 4)

Bhandari is chief India economist and Chaudhary is economist, HSBC Global Research. Views are personal

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