Call grows among market participants for shift in RBI's stance to neutral

Drop in bond yields reflects hope of smaller hikes

Ahead of the Monetary Policy Committee’s (MPC’s) statement on Friday, while market participants are certain about a rate hike, there are also growing calls for a shift in the central bank’s stance.

Economists and market watchers are divided on whether the Reserve Bank of India (RBI) will announce a change in the stance of monetary policy. According to a BS poll, the MPC is expected to raise the repo rate by 35-50 bps from the current level of 4.9 per cent. This will take the policy rate past 5.15 per cent. It was 5.15 per cent before the RBI started cutting interest rates.

Some economists expect the RBI’s next move on its stance to be more in consonance with future tightening, given the inflation rate remains well above the central bank’s comfort zone. Currently, the RBI’s position is focused on withdrawal of accommodation.

“We expect a 35-bps hike in the repo rate, along with a change in stance to neutral. Hiking the repo rate to 5.25 per cent will give two signals — one, the pre-pandemic level is not the target or terminal rate, which a section of the market believes — and second, inflation dynamics require higher rate than the pre-pandemic level,” India Ratings and Research Director Soumyajit Niyogi said. 

Market signals

Even as the RBI is seen raising interest rates, the signals emanating from government bond yields — shaped by interest rate expectations to a large extent — point towards the central bank slowing down the pace of policy tightening.

After climbing to a three-year high of 7.62 per cent on June 16, yield on the 10-year benchmark has dropped 46 bps, with the paper settling at 7.16 per cent yield on Thursday.

The expectation of a less aggressive path to future tightening has been shaped by global growth concerns and recent comments by the RBI officials about domestic inflation having peaked.

The question of the RBI’s stance plays an important role in shaping market expectations as an accommodative or neutral stance permits the central bank to smoothly execute the reduction of liquidity surplus, instead of rapid moves to drain out excess cash in the banking system. The surplus liquidity, much of which was pumped in by the RBI during the pandemic, has helped keep a lid on borrowing costs throughout the economy.

If the RBI were to straightaway move to a stance of calibrated tightening — predicted by some, including Bank of America’s Global Research team — liquidity will have to be drained out much more proactively. The current liquidity surplus is estimated at Rs 2 trillion.

“The RBI might hold off on changing its stance to ‘calibrated tightening’ in the upcoming policy as that would entail a further reduction in system liquidity, which would take the overnight rate closer to the repo rate instead of the SDF,” HDFC Bank’s Principal Economist Sakshi Gupta said.

“Growth momentum is holding up, but global headwinds have increased and, therefore, the central bank might abstain from reducing system liquidity too much for now.”

In a recent interview with Business Standard, ICICI Bank’s Head of Global Markets, B Prasanna, said while trading desks should prepare for tighter liquidity, the RBI may have to keep in mind the needs of the government borrowing programme while acting on liquidity.

Stance confusion

Over the last couple of months, the stance of the RBI’s monetary policy has been a matter of intense scrutiny and debate with the central bank itself making subtle tweaks in language, while articulating the same.

For instance, when the MPC kicked off the current tightening cycle with a surprise off-policy rate hike on May 4, the panel’s statement said it had decided to remain accommodative, while focusing on the withdrawal of accommodation.

This reading of the stance was exactly the same as that provided by the MPC after the April 8 policy statement in which the repo rate was left unchanged.

However, when the MPC hiked the repo rate again in June, this time by 50 basis points, it removed references to remaining accommodative and said it was now focused on withdrawal of accommodation.

Given that an accommodative stance typically implies rate cuts and easy liquidity conditions, the RBI’s decision to say that its stance was accommodative while raising rates had emerged as a source of confusion.

In February, MPC member Jayanth Varma had said the central bank must move away from the accommodative stance to a neutral one. Varma had subsequently said forward guidance provided by the RBI in February had constrained the central bank’s hands when it came to moving swiftly on rate hikes.