Suspended Animation: Monetary Policy December 2021

The RBI/MPC kept all rates unchanged while the stance was retained as accommodative as well with the same earlier 5:1 vote. The decision was in line with majority expectations even as front end swap rates had been indicating expectation of some hike in reverse repo. The commentary recognizes that domestic recovery is gaining traction but recognizes that since activity levels are just about catching up with pre-pandemic levels, “it will have to be assiduously nurtured by conducive policy settings till it takes root and becomes self-sustaining”. In particular, the MPC seems to be looking for a private investment recovery to lead the revival along with a strong impetus from exports. Private consumption, though posting a strong recovery in Q2 FY22, remains below pre-pandemic levels and there are risks from global spillovers, Omicron, persistence shortages and bottlenecks, and “the widening divergences in policy actions and stances across the world as inflationary pressures persist”. The balance of these assessments has led to RBI keeping the growth forecast unchanged and for the MPC to retain its accommodative stance.

The assessment on inflation seems somewhat sanguine. While the usual risks have been recognised, the forecast itself hasn’t been changed. This is contrary to market (and our own) expectation which is giving more weight to recent developments like the spike in food prices (not just vegetables), telecom tariff hikes, and incomplete pass through in electricity and LPG prices. RBI/MPC instead are relying on the cushions provided by the anticipated fall ahead in vegetable prices, good Rabi sowing, recent supply side measures from government on edible oil prices as well as the decision to cut taxes on fuel products, and firms lesser capacity to pass through owing to slack in the economy as mitigating factors that will still keep their previously assessed CPI trajectory unchanged. The table below summarizes the divergence between our expectation and that assessed by RBI with respect to the near inflation trajectory.

To be clear, forecasts are basis an assumption on degree of unwind in the recent flare-up in food prices. However, the point is that even accounting for some stress testing to assumptions our CPI trajectory for the next 2 quarters is higher and not lower when compared with our assessment in October (when it was quite similar to the RBI’s forecasts) basis the upside risk factors mentioned above.

Travel Dynamics

We must admit that maybe for the first time since 2019, the thought occurs that RBI may be missing a trick. Needless to say, this is purely our own opinion (this is our post policy note after all!) and this too is subject to a technical nuance that we will discuss below. However, first the broad framework. Central banks have been focused on a point pre-pandemic that the economy needs to re-attain and then grow beyond. This thought has been apparent in the US Fed’s commentary on labour markets as well as RBI/MPC commentary as described above. However, what matters from a macro-stability context is also the speed of travel to that point. This is especially true as the supply side is nowhere near what it used to be. Thus impatience towards attainment of the pre-pandemic state may be fraught with significant risks, and has potential to render the environment more volatile which, ironically, can further delay the attainment of the said state. The Fed seems to have recognised this which is apparent in the ‘variable switch’ that it has recently executed. Thus from a de-facto labour market targeter till recently (believing from the pre-Covid experience that inflation won’t be a bother till that state of labour market was achieved) the Fed has now understood that the path to that labour market may take longer and needs stable prices in the meanwhile. This de-facto implies that the variable of importance is now inflation basis a recognition that the speed of travel matters especially when the underlying supply side may not be as the Fed initially thought.

To be clear, and as we have highlighted before, the extent of disequilibrium in India is nowhere near what it is in the US. This is because both monetary and fiscal loosening were well calibrated and therefore largely avoided the risk of near term overheating. The Governor noted as much in the post policy media call (unfair to compare US inflation to India). However, that is not to say that the framework as described above is irrelevant to India. Speed of travel (recovery) has picked up for India as well. Furthermore, there is evidence for now that supply side may be struggling to keep up. This is seen in core CPI as well as a more tried and tested concurrent indicator, the trade account.

As can be seen from the above chart, monthly merchandise trade deficit has been expanding lately. We had noted the slowdown in export momentum in our October policy note as a possible drag on growth (https://idfcmf.com/article/5945). While this has sustained, the import side has been more sluggish to come down (possibly in line with the economic rebound over the past few months) thereby bringing to fore not just the mechanical growth aspect (X-M being part of aggregate demand) but the issue of near term economic capacity versus actual demand. A second growth drag we had highlighted then was with respect to the rapid fiscal deficit consolidation this year and the consequent space for monetary policy to run accommodative for longer. However, recent developments point to bunched up spending by the government (net spending of the order of almost Rs 3 lakh crore basis the latest supplementary grant) which will likely negate this point. The third point made then about sluggish private consumption remains but that doesn’t address the issue of near term capacity (commentary from many consumer companies suggest no real problems in product price hikes) which is the cause of our current concern.

A similar framework on travel dynamics can apply to the RBI’s policy normalization as well. Given the current emergency levels of overnight rate at 3.35 per cent, RBI doesn’t need a full all clear to start to lift this rate. Monetary policy will still be accommodative long after the overnight rate starts to go up. If our view on inflation turns out to be correct, and when looked at in conjunction with the recent pick up in trade deficit and the anticipated government spending lined up as described above, the start of reverse repo rate hikes in February may well lose the opportunity to be on top of the narrative. CPI targeting in India is still not very old, and the mere fact that RBI is a CPI targeter may not be enough to continue to anchor expectations if reaffirming actions are missing.

The Evolving Liquidity Framework

Like mentioned above, there is a technicality that maybe helps explain part of RBI’s reluctance to hike reverse repo yet. The central bank is already absorbing the bulk of system liquidity via the so called variable rate reverse repo (VRRR) facility, where the cut-offs are closer to the repo rate. This has ensured that the weighted average rate on excess liquidity with banks is already closer to the repo rather than the reverse repo rate. RBI proposes to further enhance the 14 day VRRR to Rs 7.5 lakh crore by December 31. The expectation hence is that “from January 2022 onwards, liquidity absorption will be undertaken mainly through the auction route”. If this happens then there is virtually no relevance of the reverse repo rate, but for entities that don’t have access to RBI window. Deputy Governor Patra seemed to indicate as much in his media interaction remarks. However what is not clear is that so long as this remains a voluntary tool and the overnight window at 3.35 per cent remains without a capped amount, banks may not want to lock in more amounts under 14 day VRRR than what they are doing currently. Indeed, even today the combined VRRRs on offer aren’t being fully utilised. So why should banks deploy more (as a percentage of total liquidity that is, absolute amounts parked may go up as headline liquidity increases on government spending) just because the size of window increases. Absent further information here, one has to assume that moral suasion is going to play a part.

However, even granted the benefit of doubt as above, we still can’t square the quite dovish assessment and commentary which if anything was re-emphasized in the post policy media interactions. Insofar as the durability and extent of deviation from target counts, and risks fueling expectations that become self-affirming, that should be a concern for a relatively nascent CPI targeting central bank. Also relevant here is the possibility of forecast errors where RBI doesn’t have the luxury of symmetricity (forecasts errors can happen on either side) given the emergency levels of overnight rate now being the start of travel.

Market Implications

As explained before, we had increased cash/near cash levels in our actively managed bond and gilt funds (https://idfcmf.com/article/6329). Since then we have had news of Omicron as well as a Fed pivot (the latter very much a point of concern for us earlier). It is to be noted that the first of these has implications for both growth and inflation. What really matters is which variable is further away from target and where monetary policy can be more relevant. Given that continued virus reiterations seem to be the unfortunate new reality, it is hard for monetary policy to perpetually be on hold at the current emergency levels of accommodation awaiting the current virus iteration to play its course. Also, if this means even more lags in supply response then monetary policy may well have a role in controlling the speed of travel; a realisation that seems to now be hitting the US Fed. Furthermore, since taking the cash/near cash call we have had further adverse news on both the trade as well as fiscal fronts. All told then, and recognising that the pain of carry loss is now potentially extended, we still find merit in running conservative. That said, both the extent of conservatism as well as portfolio strategy generally can change at any point as always.

Further, a point for bond market anchor has been the relatively subdued state development loan (SDL) supply so far. This is most likely expected to change in Q4 even assuming a very conservative fiscal stance by states. Also if one were to take the comments on marginally higher than expected central government fiscal deficit at face value, it implies either very aggressive cash drawdowns/treasury bill supplies or some risk that some part of the back to back borrowing for GST compensation to states comes back (it will be recalled the central government has so far subsumed this into its own borrowing calendar, thereby effectively borrowing much lesser than budgeted for itself), possibly in the Q4 calendar. Finally, and assuming that RBI has some game-plan to ensure that VRRR absorption as percentage of overall headline liquidity rises come January, money market rates are expected to continue to remain volatile thereby reaffirming the importance of our long preferred bar-belling approach to risk management in this environment.

(Suyash Choudhary is Head of Fixed Income at IDFC AMC)

20211209-081257

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