The October monetary policy was special for several reasons and one that will be remembered for a long time. We discuss five key elements of the policy announcement and our take on the same.
Inflation: The MPC’s decision to look through the recent high inflation prints while formulating monetary policy stance is apposite and shows that inflation targeting need not be conducted in a strict mechanical manner based on point estimates of CPI inflation, particularly when the economy has been impacted severely by an unprecedented shock. While the MPC continues to target CPI inflation as per the predefined target band of 4% +/- 2%, its decision to make allowances for the severe supply-shocks posed by Covid-19 allows the “flexible inflation targeting framework” to become truly flexible and adds to its credibility. As per RBI’s forecast, CPI inflation should ease from 6.8% average in July-September to 4.3% in April-June’21. Given this base case projection, the MPC has done the right thing, to exercise patience and allow the natural moderation to happen over time, aided by a favourable base, seasonal correction in food prices and continued easing of supply constraints.
Growth: RBI’s real GDP growth forecast for FY21 is -9.5% yoy, with risks tilted to the downside. Our own growth forecasts are slightly less negative at -8% yoy. With a number of high frequency indicators having recorded a sharper-than-expected sequential improvement recently, a new set of demand-boosting measures being announced earlier this week and the economy almost fully open now, there is a possibility that growth in 2HFY21 fares slightly better than RBI’s projections. While sequential improvement in growth will continue from the lows seen in April-June’20 (-23.9% yoy), GDP levels will take a long time to return to the pre-Covid-19 position; as per our forecasts, nominal GDP will touch $2.8 trillion by end-2021, which was at the same level in end-2019.
Forward guidance: Probably based on this consideration, the MPC provided a US Federal Reserve-like forward guidance, which is a master stroke. While in the past the MPC stated that it will maintain an accommodative stance for as long as it was necessary to revive growth—without committing to any particular time-frame—in the October policy it went one step further with five out of six MPC members voting to continue with the current accommodative stance even into the next financial year, given the severity of the growth shock. Explicit commitment to maintain the current accommodative stance for a defined long time-period will help to assuage fears about any potential pre-emptive triggering of exit strategy, thereby reducing the risk-premium associated with policy uncertainty. But it will help more if the MPC members can provide a US Federal Reserve-style “dot-plot” showing up to what time they expect the accommodative stance to continue based on their individual assessment of the evolving growth-inflation dynamic. This should be the next logical evolution of the MPC, in its quest to sharpen and increase the efficacy of forward guidance and central bank communication tool.
Liquidity and monetary transmission: Another additional Rs 1 trillion TLTRO was announced, which takes the cumulative liquidity support provided by RBI in excess of Rs 12 trillion since February 2020. The sizeable liquidity support provided this year was absolutely necessary, and to give credit to the central bank, the authorities had already moved to maintaining surplus liquidity in the banking system from mid-2019, to reduce any potential financial stability risks and to ensure effective and speedy transmission of monetary policy. Indeed, the weighted average lending rate (WALR) of fresh loans has reduced cumulatively by 91bps, in response to the 115bps repo rate cut delivered from March 2020, while corporate bond spreads have also reduced materially in response to the various liquidity support programmes. This has made it clear that surplus liquidity is a necessary condition to expedite monetary transmission, though there could be other critical impediments that need to be tackled separately. We think the current alignment of easy liquidity and rate stance helps to impart clarity and guide the market better, which should be maintained as long as it is necessary to support growth.
Soft yield curve control: The October policy was special on various counts, but probably more on account of the central bank’s explicit commitment to keep long-term bond yields from inching up (without mentioning any particular target level though), by agreeing to engage proactively through open market operations and use of other instruments. RBI called the yield curve a “public good” and expected various stakeholders to work towards a cooperative solution, in a competitive yet non-combative manner. We think the forward guidance to the bond market is extremely important and useful to guide market yields lower, or at least from inching higher.
It is critical that the risk-free rate, which influences the entire term structure of interest rates, is maintained as low as possible to support growth and reduce the adverse impact on the public debt dynamic. Banks cannot be expected to do the heavy lifting, both in terms of supporting credit growth and bond market, and given the enhanced borrowing requirements of the central and state governments, it is clear that active participation from the central bank is crucial to put a lid on yields. Given this inevitability, we think it made sense for RBI to have communicated upfront about its willingness to buy central and state government bonds, which will help provide comfort to market participants. Rather than cutting the repo rate any further, maintaining it at the current 4% level for an extended period of time along with the continuation of other unconventional measures like proactive bond purchases will be a better strategy under current circumstances, in our view.
