By Nageshwar Patnaik in Bhubaneswar, August 9, 2021: The Reserve Bank of India (RBI) left its key rates unchanged on Friday and continued with its easy monetary stance for the last six times on a trot. The Monetary Policy Committee (MPC) kept the key rates unchanged unanimously and reiterated its accommodative stance both on rates and liquidity. Considering the hardening inflation and looming Covid-19 third wave, it was widely expected that the committee will keep the interest rates and policy stance unchanged.

There was, however, one dissent on continuation of accommodative stance for foreseeable future. The central Bank has prioritized growth as the economy has been ravaged by the deadly wave of Covid-19 infections. It kept the benchmark repo rate unchanged at 4 percent while maintaining its “accommodative” stance. The reverse repo rate stands at 3.35 percent. While, the central bank kept the GDP growth forecast for FY22 unchanged at 9.5%, it upped the CPI inflation at 5.7% for FY22 compared to 5.1% projected earlier. Unlike the first wave, elevated inflationary pressures and record low policy rates have left the RBI with very few policy levers to support growth amid the second wave.

“In a much better position as compared to June 2021. Need to remain vigilant on possibility of a third wave,” said RBI governor Shaktikanta Das. But unlike the central banks in New Zealand and South Korea, RBI is constrained from taking a hawkish stance with slow pace of recovery of India’s sagging economy and is expected to stand put on the Repo rate till the end of this fiscal year, as the efforts to stabilize growth will remain a long-drawn process, given the threat of the third wave of COVID-19.

The primary objective of monetary policy is to maintain price stability while keeping in mind the prime objective of growth. Price stability is a necessary precondition to sustainable growth. In May 2016, the Reserve Bank of India (RBI) Act, 1934 was amended to provide a statutory basis for the implementation of the flexible inflation targeting framework. The amended RBI Act also provides for the inflation target to be set by the Government of India, in consultation with the Reserve Bank, once in every five years. Accordingly, the Central Government has notified in the Official Gazette 4 per cent Consumer Price Index (CPI) inflation as the target for the period from August 5, 2016 to March 31, 2021 with the upper tolerance limit of 6 per cent and the lower tolerance limit of 2 per cent.

The MPC maintained that growth is still sub-par and needs consistent firm traction, and that continued policy support is vital for a durable growth revival. However, despite emerging inflation risks and sharp upward revision in FY22 inflation, MPC hang on to the view that inflation has transitory aspects, led by supply-side bottlenecks, even when they see inflation hugging the higher end of their tolerance band in the near term.

The MPC have deftly maneuvered through these constraints to support growth by relying on measures outside the conventional monetary policy toolkit. With no space on policy rates, the RBI has endeavored to support growth through additional government bond purchases under Government Security Acquisition Programme (GSAP) to prevent financial conditions from tightening prematurely.

RBI will conduct two more (GSAP) operations of Rs 25,000 crore each on August 12 and 26. Though it has so far managed to keep yields low by conducting bond purchases, softening the blow from the near-record amount of sovereign debt sales this fiscal, there are clear signs of traders’ impatience. The benchmark 10-year bond yield surged to 6.23% last month, the highest since March, as investors pushed for higher yields at an auction, prompting the RBI to seek help from underwriters to rescue the sale.

Its statement on keeping a balance in on-the-run and off-the-run securities while conducting G-SAPs is welcome, but the markets were showing their discomfort with RBI’s choice of papers for GSAP and devolution of papers at cut-off yields. However, the RBI still hinted at their preference for lower sovereign risk. Even with yields inching up, the RBI will continue to strive to fix the artificially skewed yield curve and maintain its preference for curve flattening. RBI may have to stretch GSAP and outright open market operations (OMO) beyond Rs 4.5-5 trillion to manage impending demand-supply mismatch.

The RBI also reaffirmed longer tenor variable reverse repo rate (VRRRs) as the first step toward normalization amid current bumper liquidity surplus. The Central Bank plans to conduct four VRRR auctions in the fortnight beginning August 13 till September 24, to absorb surplus liquidity from the banking system. The surplus liquidity in the banking system was at Rs 8.5 lakh crore as of August 4.

The system-level liquidity will still be more than Rs 4 lakh crore after the conduct of four VRRR auctions. The RBI will continue with its overnight fixed-rate reverse repo auction. The quantum of VRRR will increase Rs by 50,000 crore with each auction. The first VRRR will be for Rs 2.50 lakh crore, the second (on August 27) will be for Rs 3 lakh crore, the third (on September 9) will be for Rs 3.5 lakh crore, and the fourth (on September 24) will be for Rs 4 lakh crore .

At the same time, Das made it clear that the VRRR auctions should not be construed as a reversal of the central bank’s accommodative monetary policy stance. However, the surplus liquidity has not necessarily percolated well across the curve or segments of the rates market as asymmetric gains in credit markets. This also raises the risk of rerouting of surplus liquidity and excessive risk taking in other asset classes.

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