Context

In the recent MPC meeting, the policy rate hike was widely expected, more anticipated were the MPC and the RBI Governor’s forward guidance on the trajectory of policy — on both monetary policy and liquidity instruments. So, how do we see monetary policy evolve over the rest of the year and beyond?

Tightening of monetary policy

• Repo rate at 5.4 per cent: In its latest meeting, the members of the monetary policy committee voted unanimously to increase the policy repo rate by 50 basis points to 5.4 per cent.
• The repo rate was 5.15 per cent in February 2020.
• So, in effect, the RBI’s policy has not only been normalised, but has actually tightened compared to the pre-pandemic level.
•  Even the lower bound of the rate corridor, the Standing Deposit Facility (SDF) rate, at 5.25 per cent is now above the pre-pandemic repo rate.

Forward guidance on stance

• The MPS indicated the retaining the policy stance rather than shifting to “neutral”.
• This retention of stance might be interpreted as being a bit more hawkish than “neutral”, which implies that rates might be both increased or cut, depending on economic conditions.
• Now that policy is largely normalised, the pace of tightening is likely to moderate.
• The urgency of aggressive rate hikes and tightening of liquidity has somewhat moderated, although risks remain.
• RBI’s research suggests that the “real natural rate” — the rate at which policy is neither loose nor tight – is 0.8-1 per cent.
• This operative interest rate is usually the three-month T-bill rate, which in “normal” times averages 10-15 basis points above the repo rate.
• Considering that monetary policy is calibrated over a one-year horizon and using the RBI’s inflation forecast of 5 per cent for the first quarter of 2023-24, the “natural” repo rate will be around 5.85 per cent.

Inflation and growth conditions

• The RBI’s growth projection for 2022-23 has been retained at 7.2 per cent, with growth frontloaded in the first half.
• CPI inflation is still forecast to average 6.7 per cent.
• Inflationary pressures are likely to wane in the second half of 2022-23, particularly if the recent drop in industrial metals prices persists over the next few months.
• A more or less normal monsoon might help in keeping food prices stable. However, risks remain.
• Robust growth prospects: Demand for consumption goods seems to be resilient, enabling some further pass-through of input costs.
• Combine this with tight labour markets and rising wage costs in some tech-oriented sectors.
• High frequency indicators of economic activity have recovered after some weakness in June.
• In addition to resilient demand, there is evidence of a closing of the “output gap”.
• Global growth: Global growth and trade are forecast to significantly slow down in 2022 and 2023, largely due to aggressive tightening by G-10 central banks and a slowdown in China.
• The IMF predicts global trade volume (both merchandise and services) to slow to 4.1 per cent and 3.2 per cent in 2022 and 2023, down from 10.1 per cent in 2021.
• With world growth and trade flows moderating, along with a drop in commodities prices, India’s export growth is likely to be lower than last year.

External financial condition

• The current account deficit remains a concern.
• India’s external balance sheet remains quite robust, as is evident from various balance of payments and debt metrics, and reportedly low unhedged foreign currency borrowings.
• Continued tightening by global central banks, particularly the US Federal Reserve over the rest of 2022, will keep India’s external financial conditions tight and likely limit portfolio capital flows.
• However, there are some signs emanating from these central banks that the hitherto front-loaded tightening might moderate going forward.
• This will take some pressure off the rupee, though, exchange rate volatility management will remain a part of the overall monetary policy management framework.

Challenge of surplus liquidity

• During the earlier phase of policy normalisation and the recent tightening, liquidity management has played an important role in influencing short-term money market interest rates.
• The current latent surplus liquidity — the existing funds with banks and the Union government’s unspent revenues parked with RBI — is over Rs 5 lakh crore.
• While the extent of liquidity surplus during the Covid months has come down, these levels are still much higher than RBI estimates of non-inflationary levels of surplus, which is around Rs 1.8-2.4 lakh crore.
• This will gradually fall with cash withdrawals and some potential RBI dollar sales in the coming months.

Conclusion

The central bank, in coordination with the government, has ensured an orderly evolution of economic conditions during a very complex and challenging environment. The exit process now will also need the same adroit use of policy instruments.

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Back2Basics: Standing Deposit Facility rate

• The Reserve Bank of India (RBI) in April 2022 introduced the Standing Deposit Facility (SDF), an additional tool for absorbing liquidity, at an interest rate of 3.75 per cent.
• The main purpose of SDF is to reduce the excess liquidity  in the system, and control inflation.
• In 2018, the amended Section 17 of the RBI Act empowered the Reserve Bank to introduce the SDF – an additional tool for absorbing liquidity without any collateral.
• By removing the binding collateral constraint on the RBI, the SDF strengthens the operating framework of monetary policy.
• The SDF is also a financial stability tool in addition to its role in liquidity management.
• The SDF replaced the fixed rate reverse repo (FRRR) as the floor of the liquidity adjustment facility corridor.
• The SDF rate will be 25 bps below the policy rate (Repo rate), and it will be applicable to overnight deposits at this stage.
• It would, however, retain the flexibility to absorb liquidity of longer tenors as and when the need arises, with appropriate pricing.

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