In its first bi-monthly review of monetary policy for the fiscal year FY23 held between Apr 6-8, 2022, the Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI) has maintained the repo rate at 4.00%, in line with market expectations. The decision was backed by complete unanimity with a 6-0 voting outturn.

Besides the prolonged status quo on repo rate, we were anticipating the RBI to restore the width of the policy corridor (Liquidity Adjustment Facility) back to its pre pandemic level of 50 bps via a 20 bps hike in the reverse repo rate in a two-step process spread over Apr-Jun 2022. However, the central bank made two surprising announcements on this front:

• The width of the policy corridor was reinstated back to its pre pandemic level in one shot instead of spreading out the adjustment process over two policy reviews.
• The reverse repo rate, which acted as the lower bound of the policy corridor, virtually stands replaced with a new overnight Standing Deposit Facility. Unlike the reverse repo window, the SDF will be uncollateralized, and hence expand central banks’ flexibility in managing surplus liquidity situations.
• The revised policy corridor now comprises of MSF rate at 4.25% (unchanged), repo rate at 4.00% (unchanged), and SDF rate at 3.75% (new).

Further, while the MPC retained its accommodative policy stance, it tweaked the language by introducing focus on "withdrawal of accommodation to ensure that inflation remains within the target going forward, while supporting growth”. The updated stance received unanimous voting of 6-0 from the MPC members.

Economic Assessment

Growth: The RBI revised lower its estimate for FY23 GDP growth to 7.2% from 7.8% provided earlier in Feb-22. On a quarterly basis, the central bank projected GDP growth at 16.2% in Q1, 6.2% in Q2, 4.1% in Q3 and 4.0% in Q4, as a favorable base exaggerates growth in H1 vis-à-vis H2.

The RBI expects support to growth from factors like good prospects for rabi output, expanding vaccination coverage, pick-up in contact intensive sectors, budgetary thrust on public capex, and rollout of manufacturing incentives in the form of PLI Scheme. However, these growth drivers are expected to be partly offset with downside risks emanating from sharp escalation in geopolitical uncertainty and the accompanying surge in global commodity prices, tightening of global financial conditions, persistence of supply side disruptions, and the expected moderation in external demand.

This is fairly consistent with our forecast of FY23 GDP growth of 7.5% with downside risks.

Inflation: While RBI derives comfort on food inflation from record high rabi harvest along with prospects of a normal monsoon in FY23, it expects additional pressure on prices of pulses, edible oils, and fertilizers due to the conflict in Ukraine. This is over and above the primary inflation risk accruing from the sharp surge in crude oil prices along with its steady passthrough to the retail consumers over the last 2-3 weeks. Expectedly, the RBI has now revised its FY23 inflation forecast sharply upwards from 4.5% in Feb-22 policy meeting to 5.7%, on the assumption of crude oil averaging at USD 100 pb in FY23. On a quarterly basis, it estimates CPI inflation at 6.3% in Q1, 5.8% in Q2, 5.4% in Q3 and 5.1% in Q4.We, however, attach a mild upward bias to RBI’s inflation forecast given the low likelihood of any material cool down in crude oil and other commodity prices within a short period. Accordingly, Acuité expects inflation to average at 5.9% in FY23. With inflation risks now getting skewed sharply upwards, RBI Governor acknowledged that controlling inflation was a higher priority for the MPC as compared to growth, in its post policy meeting conference.

Liquidity and Credit Measures

In addition to the above, the RBI also announced the following changes:

• The limit for inclusion of SLR eligible securities in the HTM category for banks now stands enhanced to 23% of their NDTL vis-à-vis 22% earlier. This will allow banks to include g-secs acquired during FY23 under the enhanced HTM limit. This is likely to support the enhanced target borrowing programme of Rs 14.2 tn set by the central government. Subsequently, HTM limits are proposed to be restored from 23.0% to 19.5% in a phased manner starting from the quarter ending June 30, 2023.
• The RBI in Oct-20 had rationalized the risk weights for individual housing loans by linking them only with loan to value (LTV) ratios for all new housing loans sanctioned up to March 31, 2022. These risk weights shall now continue for all new housing loans sanctioned up to March 31, 2023.

Further, the RBI estimated money market liquidity overhang of about Rs 8.5 tn. The central bank "will engage in a gradual and calibrated withdrawal of this liquidity over a multi-year time frame in a non-disruptive manner beginning this year”. The calibration of liquidity surplus will be driven by (i) the prevailing stance of monetary policy, (ii) commitment to ensure availability of adequate liquidity to meet the productive requirements of the economy, and (iii) enable completion of the government borrowing programme.

Developmental Measures

RBI continues to have a focus on improving customer service standards and enhance digitization of the financial sector. As part of that agenda, it has taken a few additional steps in the current policy meeting which includes (i) the appointment of a Committee to review the current state of customer service in not just banks but also in all RBI regulated entities that will include NBFCs and fin-techs where customer complaints are on the rise (ii) card less cash withdrawal from ATMs using UPI across all banks and networks which will improve the ease of transactions and also mitigate the risks of card related frauds (iii) encourage greater penetration of bill payments through the Bharat Bill Payment System (BBPS) by reducing the networth requirement of the operators to Rs 25 Cr and (iv) issue guidelines on cyber resilience and payment security controls for payment system operators in order to minimise conventional and emerging risks in such systems

Outlook on monetary policy and rates

The declining economic impact of the pandemic, progressive normalization of growth impulses, sharp upside risks to inflation and the need to be in sync with global interest rate cycle – are all conditions that warranted the commencement of withdrawal of the pandemic era monetary policy accommodation. With RBI taking the first formal step of monetary policy normalization via a sharp adjustment in the lower bound of the LAF corridor by 40 bps, the policy intent has now clearly moved back to prioritize inflation management. This also reflects in the revised policy stance, complemented with the intent to gradually curb the elevated liquidity surplus.

Given the tone of urgency in RBI’s statement to signal the altered inflation-growth dynamics, we expect the change in stance from accommodative to neutral, followed by a cumulative 50 bps hike in the repo rate in the rest of FY23 that could be delivered between August and March FY23. Further acceleration in global commodity prices could potentially tilt the balance in favor of another 25 bps repo rate hike (not our baseline scenario).

From the perspective of g-sec yields, the hawkish policy outturn (as per market consensus, no rate action of any kind was expected in Apr-22 policy) came as a slight surprise. This has pushed g-sec yields higher by around 20 bps since the policy communication, with the impact getting further exacerbated by announcement of inclusion of SDF balances under SLR maintenance for banks. While we maintain our call of 10Y g-sec yield drifting higher towards 7.25% before end FY23, there is now a higher probability of upside risk to this forecast as market expectations align with RBI’s hawkish policy pivot. Having said so, we do expect the central bank to rely on tools like Open Market Operations (OMO), Operation Twist (OT) and verbal suasion, to facilitate an orderly evolution of the yield curve and to support smooth completion of government’s FY23 borrowing programme.