Finally, some action as monetary policy committee turns the cycle 

Markets weren’t in for surprises ahead of the April monetary policy committee (MPC) meeting. Almost everyone on the street was prepared for an uneventful MPC, with status quo across all parameters, and only tweaks expected to inflation and GDP estimates. While the MPC kept the policy repo rate and stance unchanged, they have finally started to explicitly align the policy actions/guidance towards normalcy.

We see the following key developments totally in contrast to the ultra-dovish February policy (1) reversing the policy focus back to inflation over growth, (2) policy corridor being normalised to 50 basis points (bps), (3) realistic upward revision to inflation and downward revision to growth, (4) confirming the beginning of withdrawal of policy accommodation, (5) providing medium-term guidance on liquidity withdrawal, and finally (6) fading reinforcement by the Reserve Bank of India (RBI) on assisting the heavy borrowing program of the government.

The MPC has revised up its headline inflation projections sharply to 5.7 per cent from the earlier estimate of 4.5 per cent (Kotak: 5.8 per cent), accounting for the impact of the geopolitical tension that led to elevated crude oil prices, rising input cost pressures, and higher domestic prices of cereals and edible oil prices.

Given the uncertainty on the geopolitical front, the inflation estimates seem broadly realistic for now. We expect FY23 inflation average at 5.8 per cent with crude at $100/barrel.

Meanwhile, the weak global demand, tighter global financial conditions and supply chain disruptions have prompted the RBI to sharply revise its FY23 real GDP growth projection to 7.2 per cent against previous estimates of 7.8 per cent (Kotak: 7.5 per cent). RBI expects GDP growth to moderate to 6.3 per cent in FY24.

Acknowledging the increasing upside risks to inflation, the MPC has finally started the explicit policy normalisation process by narrowing the effective policy corridor to pre-covid levels of 50 bps. This normalisation of the policy corridor comes with the introduction of Standing Deposit Facility (SDF) rate, which will now define the floor of the corridor at (25bps below the repo rate), from the earlier floor of the reverse repo rate (which was left unchanged at 3.35 inflation projections).

The policy corridor now has the floor of the SDF at 3.75 per cent, and the ceiling of the marginal standing facility (MSF), which was also left unchanged at 4.25 per cent, providing “symmetry to the operating framework of monetary policy”.

According to the RBI, the fixed rate reverse repo rate will only be used periodically at their discretion, thereby effectively rendering this tool as redundant on a regular basis.

The SDF is an uncollateralised tool where banks can park unlimited surplus with the RBI, without SLR securities as collateral (unlike the reverse repo). This tool would be useful when the RBI may be at the risk of running down on securities when the liquidity surplus is massive.

While the introduction of SDF as a liquidity management tool was in the making, the timing remains in question, given that the outstanding government securities of the RBI currently at around ₹12-13-lakh crore and the liquidity surplus likely to reduce amid the Balance of Payment (BoP) deficit and currency leakage. A reverse repo hike of 40bps would also have achieved similar outcomes.

Overall, the policy actions, language and the forward guidance have decisively shifted towards being hawkish and, aptly so, in contrast to a very dovish February policy.

As the economy has broadly emerged from the pandemic shock, the MPC framework’s mandate of shifting the operating target rate (Weighted Average Call Money Rate/WACR) closer to the repo rate had to be restated.

The normalisation of the effective liquidity adjustment facility (LAF) corridor, with the floor being set at 25bps below the repo rate, will shift the overnight call rates in between the SDF and repo rate.

Given the expected surplus liquidity at least through the first half of FY23 (H1 FY23), the Triparty Repo Dealing and Settlement (TREPs) rates could still continue to hover a tad below the SDF rates.

Going ahead, the next steps towards the withdrawal of accommodation will be a shift in the stance, repo rate hikes and sterilisation of incremental liquidity (over the medium term), if any. We expect the stance to be changed to neutral from accommodative in the June policy followed by the first repo rate hike of 25bps in the August 2022 meeting. We retain our view of a 50bps of repo rate hike in FY23.

Hawkish tilt

The hawkish tilt of the policy and the limited reassurance by the RBI in terms of supporting the bond markets through open market operations (OMOs) or operation twists will continue to weigh on sentiments.

While the enhancement of the held-to-maturity (HTM) limit to 23 per cent (from 22 per cent) until March 2023 should provide brief relief to the bond markets, we do not expect this factor to be a game-changer, given the massive demand-supply gap. We estimate RBI will need to support the bond markets in the range of ₹3.5-4.5-lakh crore to manage the heavy supply.

The author is the Senior Economist of Kotak Mahindra Bank. The views and opinion expressed are personal and do not necessarily reflect the opinion of the organisation or Kotak Group

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