Policy signals calibrated tightening

The members of the RBI’s monetary policy committee (MPC) voted unanimously to increase the policy repo rate by 50 basis points (bps), taking the repo rate up to 4.9 per cent. The lower bound of the rate corridor, the Standing Deposit Facility (SDF) rate, will rise to 4.65 per cent.

While the policy rate hike was widely expected, the salience of the RBI governor’s statement and comments was more as guidance of the future trajectory of policy tightening, while balancing growth and inflation trade-offs.  

There was indeed a change in communication. In the May off-cycle review, the MPC decided “to remain accommodative while focusing on withdrawal of accommodation”. This time, the word “accommodative” was dropped; MPC simply “remains focused on withdrawal of accommodation”.  A clarification at the post-policy briefing has now made the meaning of “accommodation” crystal clear. The stance is signalled by the operating rate (the weighted average call rate (WACR) in the revised Liquidity Management Framework of February 2020) relative to the policy repo rate. Periods when the WACR consistently remains closer to the lower bound of the corridor, as is the case now, can be deemed accommodative. When closer to the repo rate, neutral, and when above, tight.

Hence, during the gradual transition to a neutral stance, maybe over the next couple of months, liquidity management will play an important role in transitioning the WACR closer to the repo rate. This will result in a fairly large move up in overnight and short-term rates, as the repo rate itself moves up. These changes are consequently likely to have significant effects on market funding and bank lending rates, which are increasingly linked to the repo rate.

The current surplus liquidity is Rs 3.2 trillion. Given the expected increase in the Centre’s spending, this is likely to increase in the near term, but passive cash outflows and probable RBI foreign exchange operations will keep these levels fairly close to the RBI estimates of non-inflationary levels of surplus liquidity. This might be a reason inter alia why the RBI chose to hold, for now, the Cash Reserve Ratio (CRR) for banks at the earlier 4.5 per cent of deposits.

Another component of communication is the RBI’s macroeconomic forecasts. The FY23 GDP growth projection was retained at 7.2 per cent, with balanced risk; growth is front-loaded in the first quarter. The CPI inflation is forecast to average 6.7 per cent, with H1 FY23 at an average 7.45 per cent. The risks to both are considered balanced. The risks to inflation, however in our view, remain on the upside, with supply dislocations expected to continue, high oil prices persisting, China policy measures gradually stimulating growth, greater pricing power in our own domestic services sectors as demand remains resilient, continuing input cost pass-throughs into consumer prices, and other factors. Combine this with already tight labour markets in some tech-oriented sectors and evidence of a closing “output gap” (Manufacturing capacity utilisation is estimated at 74.5 per cent in Q4 FY22 and to have moved up even higher thereafter). The encouraging features in this outlook are the results of the RBI quick survey of urban households after the excise duty cuts on transport fuels, showing that 3 month and 1 year ahead expectations falling significantly, which might provide room for the MPC for more calibrated rate hikes while moving towards “normal monetary conditions”.

The writer is executive vice president and chief economist, Axis Bank