A firm signal of normalisation such as a reverse repo rate hike is warranted only when the risk of another Covid surge is ruled out; cases may surge amid the busy festive season
By Anubhuti Sahay
Expectations centred on the upcoming Monetary Policy Committee (MPC) policy announcement are varying—a sharp contrast to the widespread consensus since March 2020 on rate-cuts, the accommodative stance and liquidity. Markets and economists are divided on the possibility of an increase in the reverse repo rate (fixed rate at which RBI absorbs liquidity from the banking system in an overnight window) at the upcoming policy meeting. Consensus (including us) expects the MPC to keep the repo rate (fixed rate at which RBI lends to the banking system) unchanged and maintain its accommodative stance. Currently, the reverse repo rate is at 3.35% and repo rate at 4%.
Diverging expectations on the reverse repo rate have emerged over the last few weeks, as auction cut-offs on variable rate reverse repos (VRRRs) have increased gradually, from c.3.40% to 3.99% (7-day tenor), higher than the existing reverse repo rate of 3.35%. VRRRs are also used by RBI to absorb excess rupee liquidity in the banking system, albeit for longer tenors (currently 7-14 days) and at variable rates. RBI has more than doubled the size of VRRRs since the August MPC meeting; the sharp rise in VRRR cut-offs has been interpreted by the market as an indication of RBI’s preference for a lower liquidity surplus and an exit from ultra-low rates. Higher crude oil prices, concerns on the inflation trajectory (though headline inflation is likely to print at lower than 5% over next few months) and a sharp pick-up in the vaccination pace have added to expectations of a firmer signal by RBI on the start of the rate normalisation process at this week’s meeting.
To clarify, the MPC is mandated to vote on the policy rate, i.e. repo rate only. The reverse repo rate adjusts automatically once the repo rate changes. However, the reverse repo rate was cut asymmetrically by 155 bps, to 3.35%, during the pandemic in 2020, while the MPC voted in favour of a repo rate reduction of 115 bps to 4%. The asymmetric cut, which led to the widening of the corridor (gap between repo and reverse repo rate) to 65 bps from 25 bps (pre-pandemic), was delivered to support the economy as higher inflation disallowed sharper reductions in the repo rate. The MPC is mandated to keep CPI in the band of +/-2% with a medium-term target of 4%. CPI inflation averaged at 6.2% in FY21 (year ended March 2021).
The market thus expects that, as a first step towards rate normalisation, RBI would restore the corridor to 25 bps by raising the reverse repo gradually by 40 bps over couple of meetings. As mentioned above, higher VRRR cut-offs and the broader macroeconomic backdrop have built up expectations of such a move as soon as this week.
While a reverse repo rate hike of 15-25 bps on October 8 cannot be ruled out, we think RBI will wait until the December policy meeting to make such a move. We say so for the following reasons. Unlike VRRR cut-offs/sizes and tenor, a reverse repo rate hike is a firmer signal of policy normalisation, in our view. We think a firmer signal is warranted when the risk of another surge in infections is largely ruled out; India could see an increase in Covid-19 cases amid the busy festival season (until mid-November). Equally important, a reverse repo rate increase coming close on the heels of the increase in VRRR cut-offs could increase expectations of a faster pace of policy normalisation (including a repo rate increase from early next year). However, the MPC has emphasised the need for a calibrated and gradual pace of normalisation. Deputy Governor Michael Patra stated in his mid-September speech that VRRRs are neither a signal of a rate lift-off nor of withdrawal of liquidity. We, therefore, expect the MPC to signal the start of the normalisation process from December at its upcoming meeting, in the absence of growth shocks. Concerns on upside risks to inflation are likely to be expressed amid persistent supply-side-led price shocks, even as we expect the MPC to marginally lower its FY22 CPI forecast from the current 5.7%.
On liquidity management, an increase in the VRRR size is unlikely at the upcoming meeting as the busy festival season is likely to drain out liquidity organically, in our view. A lower borrowing programme by the government further requires less liquidity to be absorbed; RBI has been buying bonds to support bond supply, which, in turn, has been offset by VRRRs to some extent. A VRRR tenor longer than 14 days is also not required at this juncture, in our view, given that RBI may be required to inject liquidity or allow maturity of a few VRRRs in selected weeks amid the festival season. However, it could start with a longer-tenor VRRR for a smaller amount of Rs 500 billion to test the market’s appetite for future deployment.
Overall, we expect the MPC to maintain the status quo on rates, stay accommodative, lower its inflation projection marginally from 5.7%, but flag possible upside risks given hardening of crude oil and natural gas prices. We also expect it to signal the possibility of normalisation from the next policy meeting if no further growth or sentiment shocks are experienced.
Head, South Asia, Economics Research, Standard Chartered Bank