Inflation fear is still not lost
The 3rd bi-monthly monetary policy committee (MPC) meeting for FY22 took place from 4th to 6th August when the economy was showing signals of recovery from the impact of the second wave of the pandemic. The economy is bouncing back at a faster rate than during the first wave of the pandemic as indicated by the various economic indicators including GST collection and PMI.
Though the high-frequency indicators are showing signs of improvement, it would be too early to say that the economy is back on the growth track. The growth support measures are needed from the central bank to sustain this momentum. Besides, the fear of a probable third wave is looming in the economy. Against this background, in an expected move, RBI kept the rate unchanged and continued with the accommodative stance.
Though the MPC voted unanimously to keep the rates unchanged, votes for the continuance of the accommodative stance were at 5:1. It shows that the inflation debate is getting more prominent. RBI has revised the inflation rate forecast for FY22 from 5.1 percent to 5.7 percent. Inflation prints for May’21 and June’21 have been above the upper band of 6 percent at 6.3 percent and 6.26 percent, respectively, making the inflation rate for Q1FY22 at 5.59 percent. The inflation rate in July’21 has cooled off to 5.59 percent, within the upper tolerance band of 6 percent. The fear of rising food prices is getting subsided as the Kharif sowing has picked up from the lows with the monsoon recovery. Yet, we need to closely watch how the inflation rate would turn out in the coming months as the inflation rate measured by Wholesale Price Index (WPI) is still in double-digit figures.
As per the recent Inflation Expectations Survey of Households (IESH), Households’ median inflation perception for the current period remained elevated at 10.3 percent. From the previous survey, median inflation expectations for three months and one year ahead period hardened by 50 basis points and 60 basis points, respectively. In such a scenario, upward revision of inflation rate for FY22 looks more realistic.
Presently, inflation rate in the domestic economy is considered transitory, triggered by supply side disruptions caused by the pandemic. Yet, if inflation persists, it could be more counterproductive. A higher inflation rate is preventing the RBI from announcing further stimulus measures. Globally, also inflation is making a strong comeback mainly triggered by the rising commodity prices and the volatility in the crude prices.
Cautious approach towards liquidity normalisation
To absorb the excess liquidity in the system, MPC enhanced the quantum of Variable Reverse Repo Rate (VRRR) auction. This could be viewed as a cautious approach in removing the surplus liquidity in the system, without disturbing the growth supporting measures of the central bank. Surplus liquidity in the system could hinder the monetary policy transmission mechanism. Yet, a sudden roll back could do more harm than good. And the RBI Governor also reiterated that the conduct of VRRR operation should not be misread as a reversal of the accommodative stance.
More OMOs and G-SAP
Governor assured that central bank would conduct Open Market Operations (OMOs) and Operation Twist as and when needed. It could bring in some relief to keep the bond yields in check. Yet, the inflation rate forecast closer to the upper band of 6 percent and higher market borrowing by the state and central government could bring pressure on the bond yields. Against the background of a higher inflation and higher inflation expectations, investors would be demanding a higher yield on the bonds. Similarly, increased supply of government bonds by both the central and state governments would lower the price of bonds. There exists an inverse relationship between the bond prices and bond yields. A lower bond price would thus result in a higher bond yield. A higher bond yield raises the cost of borrowing for not just the government but also for private investors. Government bond yields are often used as the benchmark for corporate bonds. In such a scenario, more active participation by the RBI would be needed to minimise the pressure on bond yields.
Due to limited headroom, RBI governor didn’t announce any new measures. He extended the deadline of existing interventions such on-tap targeted long-term repo operations (TLTRO). The overall tone of the monetary policy statement remains dovish. Yet, the fear of rising of inflation levels is not lost on the RBI.