Will India’s central bank go the Fed’s way on monetary policy? – The Economic Times

Clipped from: https://economictimes.indiatimes.com/opinion/et-commentary/view-will-indias-central-bank-go-the-feds-way-on-monetary-policy/articleshow/83850253.cmsSynopsis

Just as the US Fed has shown humility in admitting that it probably underestimated inflation risks, and adjusting its dot plots accordingly, MPC may admit that India’s inflation risks — though more supply- and cost-driven — need to be given more attention.

Kaushik Das

Kaushik Das

India chief economist, Deutsche Bank AGThe Reserve Bank of India’s (RBI) Monetary Policy Committee (MPC) is expected to first make a small pivot in its August policy, bringing the discussion related to managing inflation risks and inflation expectations on the table. After the hawkish pivot by the US Federal Reserve, and the sticker shock received by way of the May inflation print, this is what is expected from an inflation-targeting central bank like RBI, even while it keeps the monetary stance accommodative to support growth.

Just as the US Fed has shown humility in admitting that it probably underestimated inflation risks, and adjusting its dot plots accordingly, MPC may admit that India’s inflation risks — though more supply- and cost-driven — need to be given more attention.

As a signal to the market, RBI can — and should — increase the quantum and tenor of variable reverse repo rate (VRRR) auctions from July or August. At present, it is conducting auctions worth Rs 2 trillion of liquidity through the VRRR route, which can be increased progressively by another Rs 1-2 trillion for 28-day and 56-day tenors. While this does not reduce the quantum of liquidity, it increases the price of liquidity slowly, as more and more of the latter gets absorbed at a higher rate than the reverse repo rate of 3.35%.

This will set the stage for an eventual increase in the reverse repo rate by 40 bps during October-December 2021. If the bulk of excess liquidity eventually starts getting absorbed at the VRRR auction cut-off rate of about 3.55-3.75%, then there would be no justification of maintaining the reverse repo at the prevailing rate of 3.35%.

So, if RBI starts increasing the tenor and quantum of VRRR auctions in July-September 2021, then it is reasonable to expect an increase in reverse repo rate during October-December.

The increase in the reverse repo will be part of the normalisation process of narrowing the corridor between repo and reverse repo rate to the pre-pandemic spread of 25 bps, from the current 65 bps spread (repo at 4.0%; reverse repo rate at 3.35%). Only when this normalisation is complete will RBI look to increase the repo rate in H1 2022.

Normalisation from extremely accommodative monetary conditions —that, too, in baby steps — should not be interpreted as ‘tightening’. RBI should emphasise this in its next set of meetings to sensitise market participants.

Based on the expected growth trajectory, the medium-term risks to inflation and inflation expectations, the long lags with which monetary transmission works and the global macro backdrop of a reflationary cycle, RBI will probably hike the repo rate by 50 bps in H1 2022. While this should be the sequencing of normalisation based on output gap, inflation risks and Taylor rule formula, the current determination that RBI is showing, with respect to keeping 10-year bond yields at 6%, opens up the possibility that the central bank may consciously prefer to be continuously behind the curve as an insurance against potential growth risks in the future.

Of late, many have argued that given India’s strong foreign exchange reserves buffer, RBI need not worry about large negative real rates, as it has enough ammunition to prevent any unwarranted volatility in the forex market. While this may be true for the time being, it misses the bigger point that large negative real rates, sustained for a long period, can create non-trivial risks for misallocation of capital and mal-investments, eventually leading to a Hayekian boom-bust cycle.

As growth recovery starts gaining traction, RBI should, therefore, look to bringing real rates back to, at least, positive territory. Even if one considers an average consumer price index (CPI) inflation forecast of 5% for FY2023 (and not the current FY2022 CPI forecast of 5.8%), the repo rate needs to rise to at least 5%, for real rates to become zero. Relative to that, a 50 bps of repo rate hike in H1 2022 is forecasted at this stage. This will still keep real rates negative.

In the June MPC minutesShaktikanta Das stated, ‘A softening inflation print provides some relief and policy space enabling the RBI to step up liquidity infusion into the system….’ If the lower inflation print in April (4.2%) provided policy space for increasing liquidity infusion, as the RBI governor argues, shouldn’t then the higher May CPI print (6.3%) and the upward revision in CPI forecast for FY2022 justify reducing the quantum of liquidity infusion in the months ahead? We think it does. But will RBI bite the bullet? And, if so, how quickly?

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