In the last bi-monthly review of the fiscal year held between Feb 8-10, 2021, Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI) has maintained status quo on the key policy rates, in contrast with market expectations (expecting a 20 bps hike in reverse repo rate) while retaining the accommodative stance. This is the tenth consecutive MPC meeting where the benchmark rates have been kept unchanged. The decision on constant interest rates was unanimous backed by a 6-0 voting outturn but the one on accommodative policy continued to see a dissent with 5-1 voting outturn for the fourth consecutive meeting.

In the run up to the Feb-22 MPC decision, markets were poised for RBI to commence its monetary policy normalization with an anticipated hike in reverse repo rate by 20 bps. The swift peak of the Omicron wave, underlying core inflationary pressures, FY23 Union Budget’s growth push along with Federal Reserve’s hawkish pivot and the steep ascent in global crude oil prices had prepared the market for at least a gradual shift in the monetary policy stance. The RBI, however, chose to maintain reverse repo rate unchanged at 3.35% (and repo at 4.0%) and preferred to continue with an "accommodative stance as long as necessary to revive and sustain growth on a durable basis and continue to mitigate the impact of Covid on the economy, while ensuring that inflation remains within the target going forward”.

We believe that the central bank wants to hold on to the supportive monetary policy and augment the growth focussed budgetary initiatives of the government till the data points to a strong pick up in domestic consumption demand.

Economic Assessment

Growth: The RBI estimates FY23 growth at a healthy 7.8% compared to 9.2% (NSO estimate) in FY22. On a quarterly basis, GDP growth is expected at 17.2% in Q1, 7.0% in Q2, 4.3% in Q3 and 4.5% in Q4, as a favorable base exaggerates growth in H1 vis-à-vis H2. Having said so, RBI has acknowledged that the growth recovery is yet to acquire a broad-based nature, with private consumption and contact-intensive services both remaining below pre-Covid levels. Incremental growth support is expected to come from crowding-in of private sector investment amidst rise in capacity utilization levels and optimistic business and consumer confidence outlook.

On the downside, the MPC did recognize the persistent increase in international commodity prices including crude oil, surge in volatility of global financial markets and global supply disruptions as possible risks to growth outlook.

We are broadly in agreement with the GDP growth estimate of RBI, with our forecast currently pegged at 7.5%. However, this is based on a normal monsoon and consistently healthy agricultural output and no further threat from Covid waves.

Inflation: For FY23, RBI projects CPI inflation to soften in accordance with an envisaged glide path to 4.5% compared to is retained forecast of 5.3% for FY22. On a quarterly basis, it estimates CPI inflation at 4.5% in Q1, 5.0% in Q2, 4.0% in Q3 and 4.2% in Q4, i.e., ranging between 4.0-5.0% band through the course of the year broadly. Overall, MPC expects risks to be evenly balanced to its FY23 inflation projection, though it did acknowledge that outlook for crude prices remains somewhat uncertain amidst recent geopolitical developments.

While we do see a likelihood of CPI inflation easing in FY23 compared to our estimate of 5.5% in FY22, we do remain skeptical of the extent of moderation. This is because –

• Revision to telecom tariffs effected in Nov-21 are yet to reflect fully in inflation readings along with GST rate hike on footwear effected in Jan-22
• While the crude oil prices have inched up, it is yet to be reflected in the retail fuel prices from Nov-21 and has been absorbed by the oil PSUs so far, highlighting the risks of a pass through going forward
• Significant progress on vaccination, with India having inoculated 78% of its adult population with both doses which is likely to perpetuate demand side pressures as economy picks up
• Pass-through of elevated input costs, as seen in WPI inflation, should gather pace as growth normalizes.
• From a global perspective, prolonged supply chain bottlenecks and raw material shortages could linger well into FY23

As such, we attach an upward bias to RBI’s inflation forecast in FY23.


Liquidity and Credit Measures

RBI continues to focus on gradual calibration of the existing money market liquidity surplus. Accordingly:

• Conduct of VRR (variable rate repo) operations will henceforth get regularized in line with the evolving liquidity and financial conditions
• VRR and VRRR (variable rate reverse repo) auctions of 14-day tenor will operate as the main liquidity management tool
• These main operations will be supported by fine-tuning operations to tide over any unanticipated liquidity changes
• With effect from Mar 1, 2022, the Fixed Rate Reverse Repo and the MSF operations will be available only during 17.30-23.59 hours on all days and not during 09.00-23.59 hours. This will restore the pre pandemic level of usual timing for both these windows.

Besides continued emphasis on dynamic liquidity calibration, the central bank extended two of its special liquidity support dispensation windows (Term Liquidity Facility of Rs 500 bn for emergency health services and On-tap Liquidity Window of Rs 150 bn for contact-intensive sectors) by a period of 3-months to Jun 30, 2022.

In addition, the central bank also took steps to aid financing for two different types of economic agents:

• To encourage innovation and competition through increased participation in MSME receivables financing, the RBI upped the NACH mandate limit to Rs 3 Cr from Rs 1 Cr currently. This will make the new limits in sync with the revised definition of MSMEs while meeting their growing need for liquidity.
• The limit for portfolio debt investment by FPIs under the VRR scheme will get enhanced to Rs 2.5 tn from Apr 1, 2022 vis-à-vis Rs 1.5 tn currently. This could be marginally positive for bond market sentiments post the disappointment on lack of FY23 Union Budget’s guidance on India’s inclusion in global bond indices.

Outlook on monetary policy and rates

The progressive normalization of growth impulses, weakening economic impact of the pandemic, upside risks to inflation and the need to be in sync with global monetary policy cycle are all conditions that warrant a commencement of a withdrawal of the pandemic era monetary policy accommodation. Against a rapidly improving vaccination coverage and an investment focused FY23 Union Budget, the time was ripe for RBI to effect a reverse repo hike of 20 bps in Feb-22 in our opinion.

The status quo notwithstanding, the global and the domestic factors have already led to a spike in both short and long term bond yields by at least 50 bps since the last MPC. The importance of the reverse repo rate as a benchmark has clearly reduced with the cut-off rate in VRRR auctions close to the 4.0% repo rate. Keeping market rates stable may prove to be a challenge for the central bank and will depend on the government’s actual borrowing programme as well as banks’ credit growth over the next few quarters.

We continue to hold on to the need to restore the width of LAF corridor to 25 bps (i.e., pre pandemic state) and hence push forward our call for a 40-bps hike in reverse repo rate over Apr-22 and Jun-22 meetings. This we believe will be in line with the Governor’s telegraphed ‘calibrated approach”. This is likely to be followed by upward adjustment in repo rate during the course of FY23; by a magnitude of 50 bps in our assessment. However, the timing on the upward adjustment in the repo rate is difficult to comment on, given RBI’s thrust on growth facilitation vs the timeliness of monetary policy normalization.

From the perspective of g-sec yields, the dovish tone in the policy has pushed down yield on the 10-year paper lower (~by 9 bps) for now. Coupled with the announcement of g-sec auction (worth Rs 240 bn scheduled on Feb 11, 2022, as per the calendar) cancellation, the 10Y g-sec has now almost recouped most of its losses seen post the announcement of FY23 Union Budget (owing to higher-than-expected Government borrowing and a delay in decision on tax changes required for India’s inclusion in global bond indices has weighed on market sentiment). With central bank’s proactive balance sheet support with respect to bond purchases likely to get muted amidst the need for policy normalization, upside pressure on yields could nevertheless continue to persist. We stick to our call of 10Y g-sec yield drifting higher towards 7.25% by Mar-23. Having said so, we do expect the central bank to rely on means such as Operation Twist and verbal suasion, to support yields and ensure an orderly completion of Government’s FY23 borrowing programme.