Monetary Policy: Rationalization of Liquidity the Dominant Theme

The RBI policy announced today leaves all the base rates unchanged with continuation of the existing accommodative policy. The accommodation is to continue so long as it is required, that is, economic growth should become sustainable. That the policy would be quiet on rates and active on liquidity has been the expectation by majority of the market participants. As far as inflation is concerned the RBI has revised the expected inflation lower from 5.70% to 5.30% and the growth rate or the GDP growth has been maintained at the same level. This assumes no major threat to growth except from another disastrous wave of the pandemic which looks less likely at this juncture.

On inflation, the RBI considers the high commodity prices especially the high oil prices a threat to price stability. “There are a number of upside and downside risks to the baseline inflation forecasts. The upside risks emanate from a longer-than-expected persistence of supply chain disruptions; a further hardening of global commodity prices, especially that of crude oil; a quicker pass-through of input cost pressures to output prices on the back of strong pent-up domestic demand from ebbing infections
and vaccination-led consumer confidence; unseasonal rainfall impacting crop production; and global financial market volatility from a faster US monetary policy normalisation. The downside risks arise from an earlier than expected mending of supply chain disruptions; the persistence of weak demand and
slack in the economy; and corrections in global commodity and crude prices in the event of a weakening of global demand over new mutants and poor vaccination coverage in low-income countries.”

On economic growth, the RBI view is – “With the ebbing of the second wave, a phased relaxation of the pandemic-related localised restrictions, and improving vaccine coverage, economic activity has been normalising gradually since June 2021. Looking ahead, prospects for the agricultural sector and rural demand look promising, supported by the late revival in kharif sowing. Urban demand is also likely to accelerate with the release of pent-up demand, aided by the significant expansion in the pace of vaccination since July and improving consumer confidence……This augurs well for the sustenance of contact-intensive activities and consumption demand. The government’s focus on capital expenditure
and continued reform push, large foreign direct investment flows, congenial monetary and financial conditions, and boom in the initial public offerings provide a conducive environment for investment activity. There are signs that the investment pipeline could increase in the rest of 2021-22 and in the coming year, given the interest in the production linked incentive (PLI) scheme and the continued focus on road infrastructure.”

There are two developments which are of consequence to the markets, which is related to the continuing efforts to rationalize liquidity. The RBI had introduced GSAPs with the objective of reducing the disruptions in the fixed income market and liquidity conditions due to the government borrowing program. The GSAPs are being discontinued. A second factor of importance is that there is going to be a calendar of variable rate reverse repos (VRRRs). The VRRRs are intended to manage liquidity or rationalize liquidity while it still remains in the system. This also helps the formation of a floor for the rates which is not lower than the reverse repo rate. Both these measures will have the impact of
rationalizing liquidity and it will have consequences for the market rates.

The bond yields are set to rise further from the current levels, with the current ten-year benchmark trading at 6.27% level and looks set to move up to the 6.35% and 6.50% levels in due course. This is because of several factors which are of consequence to the yields. First, the primary issues to the tune of Rs.5 Lakh Crores is going to hit the markets month after month, and apart from this are the issues from state governments. Inflation has moderated but it is still too high for comfort, core inflation is
sticky, and inflationary pressures may mount with the rise in oil prices in the global markets and that too with a relatively weaker Rupee. The propagation of inflationary pressures through the exchange rate may have consequences for the domestic price level. This is a clear signal that the liquidity conditions may be controlled more rigorously. The high inflation prevailing in the US and Europe, and the likelihood of the Fed reducing the size of the bond buying program also may have its impact on domestic markets. The regime of low rates is passing by, and the rates at the long end of the curve are likely to move up gradually. It is clear that the RBI may not hike the base rates for the rest of the year,
the liquidity rationalization measures may gather pace. Needless to say, where the market rates are headed.




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