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RBI Policy: Between Scylla and Charybdis

As expected, RBI decided to keep policy repo rate unchanged at 4% (7th straight time) and decided to continue with the accommodative stance as long as necessary. While the rate cut decision was always going to be universally a consensus, the voting on accommodative stance witnessed a dissent. The Governor’s communication has been however very clear that RBI will do “whatever it takes” to protect growth.

While the policy strikes a delicate balance between reinvigorating growth and keeping inflation in check, it seems that RBI growth projections being retained at 9.5% is more of a statistical artefact as Q1 growth numbers have been revised upwards, while Q2-Q4 growth numbers have been significantly downgraded. Thus it is clear that the central bank currently foresees recovery as incipient which will likely lose steam as pandemic uncertainties continue to rule the roost. This provides a clear justification for central bank to continue supporting growth till it revives.

Of greater concern is the inflation projection that has been substantially revised upwards at 5.7% for FY22. Even though the RBI has clearly emphasized the inflation trajectory in upward direction to be transitory, we believe inflation management could pose a serious challenge when the elevated fuel price pass through starts to occur and thus inflation shock is unlikely to be transitory even by definition. Interestingly, the contribution of fuel, edible oil and pulses is currently more than 50% to rural headline inflation. Additionally, the second wave is having a significantly large fat tail and rural cases continue to be more than 40% in new cases, even as rural recovery continues to be patchy. This will put further upward pressure on rural inflation.

Most central banks like FED and ECB have taken recourse to the word transitory. The usage of the word transitory in the context of inflation in the statements is the new feature of FOMC statements since April. However, we must differentiate between transitory inflation in developed economies and in India. Developed economies had not seen inflation at more than 2% even after incessant QE. In India, inflation is now running close to 6% for the last one year and almost all inflation prints, headline, core, rural and urban are converging at 6% or upwards implying inflation numbers may not be transitory. In fact, in the US, over the next year, the transitory price increases caused by bottlenecks and supply constraints were expected to largely reverse, but with rise in COVID-19 cases in the US it needs to be seen to what extent the existing supply constraints will further push up the inflation.

Regarding liquidity management, RBI has maintained that the resumption of its Variable rate reverse repo (VRRR) auctions should not be misread as a reversal of the accommodative policy stance, as the amount absorbed under the fixed rate reverse repo is expected to remain more than ₹4.0 lakh crore at end-September 2021. This decision will push up short term rates towards repo rate. Also, the MSF relaxation has been extended by another 3 months till 31st Dec 2021. Banks are allowed under this relaxation to dip up to 3% of NDTL into SLR under MSF as against the usual 2%. This will provide increased access to funds to the extent of ₹1.62 lakh crore and qualify as HQLA for the LCR. To provide stability RBI has extended On Tap TLTRO Scheme till Dec’21. RBI is also conducting open market purchase of government securities of ₹25,000 crore on August 12, 2021 under the G-sec Acquisition Programme (G-SAP 2.0).

 

The report has been authored by Dr. Soumya Kanti Ghosh, Group Chief Economic Adviser, State Bank of India.

 

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