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Doves are not disturbed

* The upcoming policy will see the MPC re-emphasising its commitment to keeping policy accommodative for the foreseeable future and maintaining comfortable liquidity. The recent inflation surprises are unlikely to derail the RBI’s narrative, especially with inflation ahead likely falling back to sub 6% - within its flexible target. The MPC will likely maintain that growth is still sub-par and needs consistent firm traction, and that continued policy support is vital for a durable growth revival. We do not see any split in the voting pattern on the accommodative stance.

* The yield curve and liquidity management will remain policy focus. 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. Markets would watch out for any hint on GSAP 3.0 and the choice of securities (G-sec/SDL) mix.

* While the RBI may reaffirm its preference for VRRRs as the first step toward liquidity normalization, we are unlikely to hear any mention of it in the upcoming policy. The policymakers would tread cautiously on this front to see an orderly evolution of the yield curve, having seen extreme market reactions in the past. That said, we reckon surplus liquidity has led to asymmetric gains in credit markets and excessive risk-taking in other asset classes.

* We reckon the RBI will continue to strive to fix the artificially skewed yield curve and maintain its preference for curve flattening. We expect the RBI to get more accountable and action oriented as we move into H2FY22. We maintain the RBI may have to stretch GSAP/OMOs beyond Rs4.5tn+ to manage the impending demand-supply mismatch.

Growth focus to still take precedence amid evolving inflation risks

The MPC is likely to keep the growth narrative (and forecast) similar to June policy at 9.5%, with risks broadly balanced amid improving agri output, still-strong rural demand (even though not fully insulated), better-adapted firms, stable financial conditions, global growth spillovers and new risks in the form of delta variant or third wave/slower vaccination drive. However, they will likely maintain that growth remains sub-potential and the scarring impact of Covid would only accentuate the output gap further. Amid two inflation surprises in May and June, Q1FY22 inflation overshot the RBI’s forecast and could lead the MPC to raise its FY22 expectations marginally from 5.1% (Emkay: 5.35%). However, the MPC is likely to reinforce Governor Das’s view that inflation has transitory aspects, led by supply-side bottlenecks. With inflation likely to be sub 6% going ahead, the MPC may harp on the accommodative stance as it would again fall within the flexible target range. We note there were some emerging dissents in MPC minutes on inflation risks, but we still think that the chances of a split vote on the accommodative stance are low in the upcoming meeting.

Yield curve management to remain policy focus

The last MPC policy in June focused largely on yield management as the RBI tried to reinstate its stance on liquidity and sovereign premia by enhancing the GSAP 2.0 to Rs1.2tn for Q2FY22. The RBI has been intervening (directly/indirectly) in different segments of the yield curve since July, with an aim to target orderly evolution of the yield curve as the policy strategy of being anchored only at 10-yr yield partly became counter-productive. However, we reckon that, amid a heavy supply each week, the tussle between the markets and the RBI has continued, with markets showing their discomfort with the RBI’s choice of papers for GSAP and devolution of papers at cut-off yields uncomfortable to the RBI. We could see the RBI reiterating its support for the bond market and also indicating that they do not necessarily target any level or segment of the yield curve. However, the RBI will likely hint at their preference for lower sovereign risk premia ahead. We reckon the RBI will continue to strive to fix the artificially skewed yield curve and maintain its preference for curve flattening.

Communication on liquidity management key amid evolving market risks

The RBI has been contending with dilemmas about managing its liquidity stance since Covid first struck last year amid robust FX flows and elevated inflation pressure. 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, specifically equities. However, the RBI’s tryst with liquidity normalization with variable rate reverse repos (VRRRs) had not been very successful in the past (end-Q3FY21) and had led to shock across the Gsec curve, more pronounced at 3-5 year segments. The RBI reaffirmed longer tenor VRRRs in Apr’21 as the first step toward normalization. While they may restate this, we are unlikely to hear any action on liquidity normalization in the upcoming policy. The policymakers would tread cautiously on this front to see an orderly evolution of the yield curve, having seen extreme market reactions in the past.

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