RBI MPC likely to keep policy rates unchanged, stance accommodative; may update inflation forecast

December 01, 2020 2:58 PM

The RBI may also want to share its views on recent developments such as the liquidity glut at the short end and its likely strategy on it

RBI, RBI MPC, interest ratesAs these special bonds are non-interest bearing and issued at par to a bank, it would be an investment, which would not earn any return but rather depreciate with each passing year.

By Sudhakar Shanbhag

The RBI faces a challenge of elevated inflation, high government borrowing and large capital inflows. CPI inflation has been outside the 2-6% tolerance band for seven months. Alongside, public sector borrowing is likely to rise to about 16% of GDP in FY21. The RBI has understandably stepped up on state and central government bond purchases to manage the elevated supply. Finally, and most importantly, foreign capital inflows remain strong, initially led by FDI inflows, and lately more by FII inflows. The RBI has been intervening actively in the FX market. Since early April, its foreign currency assets have risen by USD90bn.

FX purchases have been a stronger driver of surplus domestic liquidity than bond purchases. If the RBI doesn’t intervene in the FX market, the rupee could appreciate, hurting export competitiveness. If it does intervene, it would add to the already elevated banking sector liquidity, stoking inflation worries further. It’s difficult to predict when these large foreign capital inflows will stop.

Fiscal and monetary policymaking around the world has become far more adventurous and unconventional. The last few months have witnessed a dramatic rise in the use of terms such as Modern Monetary Theory (MMT), ‘no more austerity’, QE-infinity, yield curve control (YCC), and so on. And these have implications for EMs.

Even if EMs do not pursue many of these unconventional policies, they could still find themselves at the receiving end of loose policy in advanced economies. And that could turn out to be a double-edged sword. On the one hand, advanced economies would be doing a lot of the easing of financial conditions for EMs. But on the other hand, the large quantum of easing could become a policy headache for some. For instance, loose policy abroad resulting in continued inflows into India, stoking domestic worries such as inflation.

The RBI will perhaps have to juggle deftly through this period, striking a balance between its objective on inflation, bond yields and the rupee. To this end, the RBI will be well served by not making changes to the repo rate (currently at 4%) or its accommodative stance in the upcoming policy meeting. However, it may have to update its macro forecasts on inflation and growth. The RBI may also want to share its views on recent developments such as the liquidity glut at the short end and its likely strategy on it.

(Sudhakar Shanbhag is Chief Investment Officer at Kotak Mahindra Life Insurance Company Limited. Views are the author’s own.)

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