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* The upcoming policy will see MPC re-emphasizing its commitment to keeping policy accommodative for the foreseeable future and maintaining ample liquidity. However, there will likely be some reassessment of the growth outlook even as the RBI may not rush to reduce its FY22 growth forecast of 10.5% dramatically amid the second wave of Covid-19 and series of local lockdowns. The MPC is likely to maintain that growth needs consistent firm traction and that the continued policy support is crucial for a durable growth revival.

* While the Q4FY21 inflation forecast may be revised down a tad, the risks of increasing input costs and commodity prices, seasonal or new supply disruption-led upside in food prices and better pricing power could prod MPC to relook at its FY22 inflation forecast. However, local lockdowns, if persist, could impact services demand negatively, put downward pressure on Q1FY22 core inflation and act as a balancing factor to emerging upside risks to inflation.

* On the yield curve management, the RBI will again assuage markets and continue to ensure that no premature tightening of financial conditions would happen and that the uptick in yields is managed smoothly. We expect the RBI to become more accountable and action oriented as we move into FY22. The RBI will continue to strive fixing the skewed yield curve and maintain its preference for curve flattening. We expect net OMO purchases to the tune of Rs 4.5-5tn in FY22 amid elevated supply, some natural normalization of liquidity in FY22 and shifting out of banks SLR demand.

Assessing the incipient growth risks…

The last MPC policy in February focused largely on the tussle between markets and the RBI on elevated yields, emphasizing on its commitment to keeping policy accommodative for the foreseeable future and maintaining ample liquidity. While there has been some easing of tension in the bond markets in recent days (admittedly more owing to cancellation the last bond auction than the RBI’s verbal interventions), the evolving macro situation probably needs more focus. The sense of growth comfort seen in the last policy amid improving capacity utilization and reviving consumer confidence would likely be reassessed in the upcoming policy. While we do not expect the MPC to revise down its FY22 growth forecast of 10.5% (Emkay: 10.5%), we reckon the policy tone in growth will be concerning amid the new wave of Covid and localized lockdown, which if takes a broad-based shape, could dent their Q1FY22 forecast of 26.2%. We note that Maharashtra, which has seen a stricter localized lockdown, contributes the most to national GDP (14% share). Lead indicators are also pointing to mild sequential moderation in activity. While it is too early to gauge the impact of the second wave on macro variables, we believe that the impact is unlikely to be of the same magnitude as last year as (1) a segment of the economy has already adapted to the new post-Covid normal, (2) the vaccination drive continues its traction, (3) revenue spending trends much better, (4) financial conditions are more stable, and (5) global growth, led by US, will have spillovers.

…while keeping an eye on evolving inflation risks

We expect the MPC to lower the Q4FY21 inflation forecast by 20-30bps, but the risks of 1) increasing input costs, 2) higher commodity prices, 3) seasonal upside in food prices and possible re-emergence of food supply disruptions due to localized lockdowns, and 4) better pricing power could prod MPC to relook at its FY22 inflation forecast. However, local lockdowns, if persist, could impact services demand negatively, put downward pressure on Q1FY22 core inflation and act as a balancing factor to emerging upside risks to inflation. Thus, there may not be much tinkering with inflation forecasts but reaffirmation of evolving both upside and downside risks.

Liquidity management and smooth yield curve evolution to remain policy focus

In the upcoming policy, the RBI will continue to assuage markets on managing liquidity and the heavy Gsec borrowing schedule ahead. Consistent verbal interventions, however, have had a limited market impact so far. Thus, the RBI may continue to ensure that no premature tightening of financial conditions happens and that the uptick in yields is managed smoothly. We expect the RBI to get more accountable and action oriented as we move into FY22. We think the liquidity management will be calibrated well to ensure that the accommodative stance is maintained, money market skewness is tackled and pressure on the longer end of the curve is managed well. With elevated borrowings, policy rates likely having bottomed out and increasing global yields, the appetite for a duration risk on G-Sec will likely fade. Thus, RBI support in the form of vigorous OMOs/OT will be required to maintain the demand-supply balance and manage pressure on the longer end of the curve. Amid some natural normalization of liquidity in FY22 (CRR reversal, halving of BoP surplus to USD50bn, increasing CIC) and shifting out of banks SLR demand will mean that net OMO purchases could reach close to Rs4.5-5tn in FY22. The RBI will continue to strive fixing the skewed yield curve and maintain its preference for curve flattening. After all, a lower welfare cost of public debt may be needed when public funds are used for investments addressing growing economic externalities.

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