Status Quo On Policy Stance But Liquidity Sugar Rush Should End


At its last meeting, the US Federal Reserve’s rate-setting body, the Federal Open Market Committee (FOMC), opted for status quo but made it clear that tapering of quantitative easing could begin as early as November and end by mid-2022.

Over the next two years, policy rates are likely to move higher. The Fed’s dot plot, a chart that summarises the FOMC members’ outlook for the federal funds rate, gives us a sense of how these rates could rise between 2022 and 2024. The Fed has upgraded its inflation projection, which could be more persistent in the medium-term, and lowered its growth projections.

The Bank of England, too, has kept its main interest rate unchanged at 0.1 per cent and stuck to its asset purchase programme. But it has downgraded economic growth projections for the third quarter of this year and warned of higher inflation. The case for policy tightening has started gaining momentum with two members of Bank of England’s Monetary Policy Committee voting for an early end to its government bond purchase programme.

Since the August meeting of the Reserve Bank of India’s (RBI) rate-setting body, the Monetary Policy Committee (MPC), at least seven central banks have raised policy rates, the latest being Norway’s central bank, which has hinted at yet another rate hike in December.

What can we expect from MPC’s three-day meeting that ends on October 8?

Weeks after its last meeting in August, Jayanth R Varma, the lone voice of dissent in MPC, batted for the removal of “some of the accommodation which is no longer needed” to “reduce the risk of loss of credibility (for MPC)” with “inflation becoming more entrenched”.

RBI Governor Shaktikanta Das responded swiftly, saying the central bank wouldn’t do anything in haste that may undermine financial stability in the medium term. “We need to wait for the growth signals to become more sustainable. We need to see that … the economic revival… the fast-moving indicators are not just fast moving, but take some roots… Any policy action by the RBI, particularly monetary policy action, has to be very carefully calibrated and well-timed,” he said.

Recently, RBI deputy governor and MPC member Michael Patra reiterated Das’s stance, saying, “We don’t like tantrums. We like tepid and transparent transitions, glide paths rather than crash landings.” The RBI will gradually wind down its accommodative monetary policy stance as inflation moderates to 4 per cent by 2023-24, Patra said. He expects inflation to moderate to 5.7 per cent or lower in financial year 2022 and below 5 per cent in 2023.

What has changed since the August meeting?

The retail inflation cooled to a four-month low of 5.3 per cent in August, from 5.59 per cent in July, because of two factors – lower food inflation and the high base of last August. The core inflation, or non-food, non-oil, manufacturing inflation, eased to 5.5 per cent in August from 5.7 per cent in the previous month. For two successive months now, retail inflation has been below the 6 per cent upper tolerance threshold of the MPC. Most analysts expect it to drop further and remain below 5 per cent till December before it starts rising again in January.

The prospects for growth, on the other hand, have brightened. Some of the high-frequency data has started showing signs of recovery and rising consumer demand.

The RBI has projected 9.5 per cent real GDP growth for fiscal year 2022; the inflation projection of the year is 5.7 per cent (it was raised in August from 5.1 per cent) “with risks broadly balanced”.

At this point, both the projections seem realistic and the central bank may not tinker with them now.

No prizes for guessing that monetary policy’s stance will remain accommodative. The RBI is not expected to change it till growth is secured, although there could be dissenters at the MPC meeting. However, without being explicit, the central bank may kick off a subtle normalisation process, restraining the flow of liquidity.

The excess liquidity in the system is at its historic high now – around Rs12 trillion or more, including the government’s surplus funds.

At the August policy, the RBI announced doubling the size of the 14-day variable rate reverse repo (VRRR) auctions from Rs2 trillion to Rs4 trillion in the second quarter of the financial year. Das had strongly emphasised that the increase in the size of the auction was nothing but a tool for liquidity management. Along with this, the RBI has been conducting shorter maturity VRRRs for 7 days, 4 days and 3 days.

The central bank has also shifted its forex intervention in the forwards market to refrain from injecting rupee liquidity. For every dollar it buys (to rein in appreciation of the local currency), an equivalent amount of rupee liquidity flows into the system. The RBI has been entering into sell-buy swaps in the forwards market to stall this.

Will the RBI stop its secondary market government securities acquisition programme, or G-SAP, an Indian version of quantitative easing? In the first quarter of 2021, beginning April, the size of G-SAP 1.0 was Rs1 trillion. It was raised to Rs1.2 trillion for G-SAP 2.0 in the second quarter. But the last two G-SAP auctions, Rs15,000 crore each, have been converted into twists, linking a sale leg to the bond purchase programme.

The RBI could refrain from announcing G-SAP 3.0 or convert it into a twist, making it liquidity neutral. Or, it may even go for a monthly G-SAP calendar, instead of quarterly. The liquidity measures are soft-touch normalisation. They started in August but must gain momentum now.

The 3.99 per cent cut-off yield for the seven-day variable reverse repo auction on September 28 encourages one to expect an increase in reverse repo to narrow the gap between the repo and reverse repo, the so-called liquidity adjustment facility. But at this point, I read the higher cut-off yield more as a signal to drain liquidity than raise the rate. The RBI is unlikely to raise the rate without preparing the market for it. Can it happen in December?

Withdrawal of excess accommodation in the form of liquidity sugar rush is akin to taking away the training wheels from a kid’s bike. Yes, training wheels help kids maintain balance and stay upright on a bike and pedal at an earlier age but they don’t teach them how to ride a bike.

The fiscal health of the government is improving with higher tax collections, and consumer demand has started picking up. As the path looks less treacherous now, it’s time to remove the training wheels.

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