RBI lets Schrodinger's cat out of the bag, admits rate corrections can't fight inflation for now
A rate hike arrests monetary inflation, or rising prices due to increasing money supply. But given the present inflation is due to global supply bottlenecks, rate corrections are simply useless.
It appears that inflation has entered the state of Schrodinger's theory, where price rise is both temporary and persistent simultaneously.
On Wednesday, the RBI confirmed that headline inflation will likely peak in January-March 2022, and should ease thereafter. But unlike in the past, Governor Shaktikanta Das has not only retired the 'transitory' phase for 'stubborn' inflation, but also decided not to take the foot off the policy pedal.
In other words, the textbook remedy for arresting persistent price pressures via rate hikes is off the table and the key policy repo rate will squat at 4% until further notice. A rate hike arrests monetary inflation, or rising prices due to increasing money supply. But given the present inflation is due to global supply bottlenecks, rate corrections are simply useless. So the central bank's Monetary Policy Committee (MPC), kept key policy rates and stance unchanged. Reverse repo rate too stands at 3.35%. Traditionally, the gap between repo and reverse repo rates is 25 bps and reducing the gap is the first step towards eventual rate hikes.
Just until last week, a hike in reverse repo rate to narrow the rate corridor and set the ground for actual lift-off appeared certain, but that too has been put off until next year, thanks to the trinity of concerns -- new virus variant Omicron, persistent price pressures and global supply bottlenecks.
For now, the central bank hopes to align rates without the noise around a rate hike. In fact, it has been doing so since at least since October, where excess liquidity was absorbed via 14 and 28-day Variable Reverse Repo Rate (VRRR) auctions, which in turn firmed up short-term rates. Policywatchers expected a reverse repo rate hike on Wednesday officially confirming a faster policy normalisation, but Governor Shaktikanta Das announced that tapering will now proceed at a fairly leisurely pace.
Assuming the government's supply-side measures to contain food prices and fuel tax cuts may alleviate domestic cost-push build-up, inflation estimates were retained at 5.3% for FY22. Headline inflation is expected to peak in Q4 and soften thereafter, but will continue to stay at around 5% in Q1 and Q2 of FY23.
Elevated energy and commodity prices, potential volatility in global financial markets due to a faster normalisation of monetary policy in advanced economies and prolonged global supply bottlenecks could irk domestic outlook. That said, as Das noted, price stability remains the cardinal principal for monetary policy and that the central bank will 'ensure soft landing that is well timed.'
The recovery interrupted by the second wave of the pandemic is regaining traction, but isn't strong enough to be self-sustaining and durable, which is why, RBI believes the key policy rate must squat at 4% indefinitely. Incoming data shows consumption demand improving, and is expected to fare even better due to the recent fuel tax cuts. The government's focus on capex, the deleveraging of corporate balance sheets, rising imports and production of capital goods give enough reason for cheer and so real GDP growth estimates too were retained at 9.5% for FY22 despite uncertainty surrounding Omicron virus, global spillovers and any knee-jerk reaction of Indian and global financial markets to US Federal Reserve's monetary policy action.
System liquidity remains in the surplus mode with the average daily net absorption under the liquidity adjustment facility (LAF) at Rs 7.6 lakh crore in November, 21. To rebalance the surplus, Das noted that the objective was to re-establish the 14-day VRRR auction as the main liquidity management tool. Accordingly, the central bank will enhance the 14-day VRRR acution amounts on a fortnightly basis of Rs 6.5 lakh crore on December, 17 and further to Rs 7.5 lakh crore on December, 31. From January 2022 onwards, liquidity absorption will be undertaken mainly through the auction route, while any unanticipated and one-off liquidity flows will be managed and complemented by 28-day and even longer term VRRRs.