Monetary Policy: Market sniffs an approaching normalization

In the monetary policy review by the RBI, all the key rates have been left unchanged. This is on expected lines, and RBI continues to lay accent on the need to sustain growth in preference to price stability, and therefore, an accommodative policy. Inflation is still very close to the RBI’s target range, though a shade higher than the ceiling. Something which market participants have been eagerly looking forward to is the language and tone of the policy statement. When no substantial changes are taking place, the tone of the policy statement would convey more about the things to come.

Inflation may moderate: Inflation is projected at 5.70% for the current year, that is, very close to the 6% upper band. This is on the higher side. RBI is of the view that the headline inflation has risen on account of supply shocks, sector specific demand-supply mismatches, and spill-overs from high global commodity prices. Core inflation has shown some moderation. The moderating factors such as widespread monsoon, the good kharif sowing, good stocks of food grains etc. may help keep the prices low. Moderation in prices of edible oils and pulses in July on the back of supply side interventions by the government is also expected. The RBI statement reads like this, “the available data point to exogenous and largely temporary supply shocks driving the inflation process …. The supply-side drivers could be transitory while demand-pull pressures remain inert, given the slack in the economy. A pre-emptive monetary policy response at this stage may kill the nascent and hesitant recovery that is trying to
secure a foothold in extremely difficult conditions.”

Growth is gradually picking up: The domestic economic activity has started normalising due to the gradual opening up of the economy. The high-frequency indicators point towards a revival of consumption, investment, and external sector. With easing of restrictions and aggressive universal vaccination, private spending and consumption including travel, tourism etc. would also start picking up leading to further recovery in aggregate demand and economic activity. The outlook for agriculture, rural demand and consumption, automobiles sales, electricity consumption, consumer durables sales etc. are also growing. The GDP growth projection is at 9.50% for 2021-22. The projections are lower for the periods beyond Q1. While the risks to growth remain potent as we progress into the year, the perception is that growth is more certain, and the fog of uncertainty is gradually evaporating.

VRRR Auctions for liquidity management: The Variable Rate Reverse Repo or VRRR auctions were
re-introduced on Jan 15, 2021. RBI had initially absorbed Rs. 2 Lakh Crs, and the same was rolled over in the subsequent fortnightly auctions. The fixed rate overnight reverse repo has been open parallel to this. RBI got good response from the markets to the VRRR in terms of the bid-cover ratio in the auctions. A series of VRRRs have been announced by the RBI which would mean temporary withdrawal of a certain amount of liquidity. The RBI will conduct fortnightly VRRR auctions of Rs.2.5 Lakh Crs on August 13, Rs.3.00 Lakh Crs on Aug 27, Rs.5 Lakh Crs on Sept 9, and Rs.4.00 Lakh Crs on Sept. 24, 2021. The Governor has stated that this should not be construed as a liquidity normalization exercise. While the market may not interpret it entirely as a normalization exercise, the need to hold such an operation would point towards excessive liquidity in the system, and there is no significant credit growth that is happening. A more important objective of such an operation is to carry out adjustments in the short-term rate. Quite often due to the easy liquidity conditions the short-term rates may trade at levels lower than the Reverse Repo Rate, and the yields on even short-term bills also have been somewhere close to the policy rate. The VRRRs would help in pushing up the short term rates a bit to correct this anomaly. It may also be stated here that short term rates may edge higher due to this, but not very significantly.

G. SAPS will support government borrowing program: The RBI is to pursue the secondary market
G-sec acquisition programme (G-SAP) with the objective of providing stability to the long end yields, and to help the government borrowing program sail through smoothly. This is key to keeping the market insulated from any disruption emanating from the huge primary issues in the long end government securities. Some Perspectives: The monetary policy is in transition towards normalization, and with normalization in growth, normalization in liquidity too may happen. While there may not be any policy rate changes in this calendar year, the actions towards normalization of liquidity are likely to accelerate in the second half of financial year. The statement that is more significant is this – “The MPC continues to be conscious of its mandate of anchoring inflation expectations as soon as the prospects for strong and sustainable growth are assured.” The short-term rates may edge higher from hereon, and the long end also may display some pressure. The ten-year benchmark may first target 6.35% and subsequently
6.60% as the policy gradually sheds its growth-character. Investment suggestions do not change but focus on very short end of the curve.



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