Make haste slowly: Inflation is a concern, but growth worries require adequate liquidity

The significant change in the Monetary Policy Committee’s (MPC’s) stance on Friday, to one that is less accommodative and accords priority to inflation concerns over growth, was quite warranted. The fact that the pricing of the Standing Deposit Facility (SDF), now the effective floor of the liquidity adjustment facility (LAF) corridor, at 3.75% was a little more than what the markets had bargained for suggests that RBI is seriously concerned about the impact of the Russia-Ukraine conflict. To be sure, a 60 basis points cut in the GDP growth output, to 7.2%, for FY23 is very worrying.

But the central bank’s inflation forecast of 5.7% for this year is rather optimistic, even if it is a 120 basis points increase over the earlier forecast, and seems more like an interim rather than a final assessment of the price pressures building up in the economy . For one, there is uncertainty on crude oil prices, which are ruling at above $ 100 per barrel, as also a host of other commodities including edible oil. Again, core inflation is tipped to cross 6% as manufacturers pass on the higher cost of inputs to consumers.

As such, the inflation forecast would probably be raised very soon, followed by a change in the monetary stance to neutral. Indeed, RBI has clearly signaled the rate cycle is turning even as it has hinted it has some tools that would help it see through the government borrowing program. This means the benchmark yield can gradually move up to 7.4% levels in the next six months; they closed at 7.12% on Friday. The central bank now appears reconciled to yields moving up gradually, though it would work to keep the curve flat by letting rates at the short end go up. Moreover, even if the repo rate hikes are kicked off in June or August, as is expected, RBI will likely stagger the increases. The fact is it would need to support growth, and is likely to focus a lot more on liquidity management.

RBI has chosen to continue the normalization process by narrowing the LAF corridor to 25 basis points using the overnight SDF at 3.75%, which is a good 40-bps higher than the fixed reverse repo rate of 3.35%. Using the SDF as the key rate with which to absorb liquidity is a good move since it would remove the need for collateral. Earlier, the central bank was soaking up excess liquidity through VRRRs. Also, as the government borrowing plan gets going, the bond markets would look for open market operations which RBI might conduct. It will help that banks can now park more bonds in the held-to-maturity category with a higher cap of 23%.

Indeed, it would be critical to manage sustainable liquidity and maintain financial stability as the system moves from a surplus of Rs 8.5 trillion to a surplus of probably Rs 2-2.5 trillion. The central bank has reassured the markets the withdrawal would take place over a ‘multi-year’ timeline. That there has been a sharp 60 bps downward revision in the GDP growth forecast is evidence that the economy needs hand-holding. RBI acknowledges consumption demand remains at below pre-pandemic levels and the weakening external demand could take the sheen off exports. Rural demand has been very weak and might not revive meaningfully even after a bumper rabi crop given the terms of trade for agriculture can be adverse with input costs shooting up. As such, liquidity in the system should remain ample so that loan rates do not shoot up. That then could stymie demand for credit and hurt the recovery.

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The significant change in the Monetary Policy Committee’s (MPC’s) stance on Friday, to one that is less accommodative and accords priority to inflation concerns over growth, was quite warranted. The fact that the pricing of the Standing Deposit Facility (SDF), now the effective floor of the liquidity adjustment facility (LAF) corridor, at 3.75% was a…

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