Timing the policy rate cycle

Sameer Narang | Updated on April 08, 2021

Growth amidst pandemic   -  vkbhat

The RBI’s move to normalise rates will hinge on inflation, growth and the global monetary policy cycle

The Monetary Policy Committee was expected to keep the policy rate unchanged and it did. Rates have been kept unchanged since May 2020. The RBI has been relying on forward guidance — monetary policy stance and liquidity — to guide markets.

Since October 2020, the RBI has been giving time-specific guidance wherein MPC members voted to continue the accommodative stance in 2020-21 and into 2021-22. The RBI did not give any time specific guidance in the April policy review. Instead, it reverted to growth specific guidance wherein the MPC will maintain accommodative stance till such time growth revives on a durable basis and the impact of Covid-19 on the economy is mitigated.

The RBI gave precise growth forecast for the next four quarters at 26.2 per cent in Q1 2021-22 from [(-) 24.4 per cent last year], 8.3 per cent in Q2 2021-22 [(-) 7.3 per cent], 5.4 per cent in Q3 2021-22 [0.4 per cent] and 6.2 per cent in Q4 2021-22. For 2021-22 and 2022-23, RBI expects 10.5 per cent and 6.8 per cent growth respectively. The RBI’s growth outlook is consistent with global recovery. The IMF projects global growth to recover from (-) 3.3 per cent in 2020 to 6 per cent in 2021. The world economy is expected to grow by 4.4 per cent in 2022. Global growth recovery is led by the US and Asian emerging markets. The US is expected to grow by 6.4 per cent in 2021 after a contraction of 3.5 per cent in 2020. Asian EMs are expected to see a growth of 8.6 per cent after a decline of just 1 per cent in 2020.

India rebound

While India has been hit harder with an estimated contraction of 8 per cent in 2020-21, it is also expected to see a stronger rebound at 12.5 per cent in 2021-22.

While there is no time specific guidance by the MPC, durable growth revival is time contingent. Even at the end of June 2021, GDP will still be 5 per cent lower than the level seen in June 2019. It is only in October 2021 that GDP will be at the same level as October 2019. Thus, the first half of FY22 will go only towards recouping the loss of output due to the pandemic.

The second Covid wave hitting India and a number of economies across the world implies there is some downside risk to growth, particularly till such time a large proportion of population is vaccinated. This is also a time contingent activity given the supply constraint around availability of vials.

Given the relatively larger impact on India, what does it mean for lift-off of rates? By when should the RBI look at normalising policy rates particularly when it foresees the CPI inflation remaining above its target of 4 per cent in the foreseeable future? This should be looked at with three considerations in mind.

First, inflation. The RBI’s current assessment is that inflation will be at 5 per cent in 2021-22 and 4.7 per cent in 2022-23. This implies the RBI’s current policy rate at 4 per cent will be below inflation by 1 per cent. If inflation starts to get broad based or inflation expectations start inching up, it may have to move sooner than later. Running negative real policy rates is consistent with most global central banks looking at giving emphasis to growth over inflation.

Second, global monetary policy cycle. The US FOMC has indicated that it will maintain current rates till 2023. A few members now believe they may have to raise rates in 2023. Since the global financial crisis, inflation has remained below the US Fed’s explicit target of 2 per cent. Given the economic rebound and the sharp increase in global commodity prices, it is expected to go beyond that level this year. But the bigger question is, will it sustain there? While asset prices continue to move higher, US labour market will take time to recoup the losses seen from the pandemic. This gives the RBI time to normalise its monetary policy well ahead of the US Fed. Third, growth itself. By the current RBI projections, India’s GDP will be at the same level as it was two years ago in October 2021. Thus, the RBI can wait till then to normalise monetary policy, which would require reduction in the rate corridor (difference between repo and reverse repo rate) from the current level of 0.65 per cent. It may also consider moving the operating rate closer to repo rate of 4 per cent.

This will also bring down the spread between long-end yields and short-end yields in a meaningful way. In order to maintain a semblance of normality in long-end yields, the RBI announced a G-Sec Acquisition Programme (GSAP), of ₹1 lakh crore in Q1 2021-22 with ₹25,000 crore of purchase on April 15 itself. The magnitude of G-SAP has comforted the bond market.

The RBI’s net bond purchases in 2020-21 were ₹3.13 lakh crore. This will give the RBI time to eventually raise repo rate in early 2022-23, well ahead of the change in the US monetary cycle, if at all in 2023. It will also give ample time to the Indian economy to recover and be ready for take-off.

The writer is Chief Economist, Bank of Baroda

Published on April 08, 2021

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