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Slow and steady transition

* The upcoming policy will be watched for the RBI’s stance on liquidity management. While the RBI may not shock the system with a reverse repo hike, the policy will be used as a lever to prepare markets for a gradualist approach toward normalization through both communication and action. Markets will still be assuaged that no premature tightening of financial conditions will happen and the uptick in yields will be managed.

* Liquidity deluge dilemmas will continue. The RBI has so far focused on redistribution and repricing of existing liquidity via VRRR tenor/quantum/cut-offs. It has now finally moved a step ahead-- reducing further active liquidity infusion by 1) sterilization of its recent GSAP instalments with a simultaneous sale of bonds (OTs), 2) possible higher intervention via the FX forwards route, and 3) partly rolling over its maturing FX forwards book.

* These tools will remain preferred tools for liquidity management ahead. While GSAPs will get shallow and sterilized ahead, we do not see the RBI deploying any direct tightening tools like MSS, CRR hikes, FX swaps or outright OMO sales in the coming quarters. Instead, we expect the RBI to let natural stabilizers like increased credit offtake and high CIC etc. to reduce the liquidity surplus.

* The MPC will likely signal further confidence over recovery and may lower inflation forecast by 30-40bps, but will instate caution on upside risks via imported inflation and its pass-through.

Liquidity conundrums are getting sticky

The RBI has been contending with dilemmas on managing its liquidity stance since Covid first struck last year amid robust FX flows and elevated inflation pressure. Surplus liquidity has not necessarily percolated well across the curve or segments of the rates market amid asymmetric gains in credit markets and risks of rerouting of surplus liquidity and excessive risk-taking in other asset classes. It is arguably correct that, amid an imminent recovery, such high system liquidity may not be warranted.

The opinion split within the MPC reflects some members’ unease with extraordinary liquidity and skewed overnight market rates. The RBI’s tryst with liquidity management with VRRRs has been relatively smoother this time, unlike the signaling in Dec’20, which led to market stress but helped little to raise money market rates meaningfully. With growth recovery still on track, the RBI will likely explore options to calibrate an exit strategy through both communication and action.

Communication on liquidity management key amid evolving market risks

The RBI’s liquidity conundrum is finding little respite. The current liquidity flux looks somewhat sticky ahead, with an increase in currency in circulation being offset by government drawdown in surplus (implying increased spending) and possible capital flows. The RBI so far has been trying to redistribute existing liquidity and increase the price of liquidity by higher VRRR tenor/quantum/cut-offs.

But the recent actions were a step ahead, signaling a further reduction in active infusion with 1) the sterilization of its last GSAP instalments with a simultaneous sale of bonds (OTs), 2) possible higher intervention via the FX forwards route, and 3) partly rolling over its maturing forwards book. These tools will remain preferred tools for liquidity management ahead. However, these actions still reflect a move toward liquidity management/redistribution/re-pricing but are still short of actual liquidity tightening.

No shocker but RBI to tread cautiously on market preparation

The policymakers would tread cautiously and ensure an orderly evolution of the yield curve, having seen extreme market reactions in the past. While GSAPs will get shallow and sterilized ahead, the other tools mentioned above will remain preferred tools for liquidity management and will serve as a precursor to a reverse repo hike at the ensuing MPC meets.

Liquidity tightening, however, may not be targeted in the coming months. We do not see the RBI deploying any direct tightening tools like MSS, CRR hikes, FX swaps or outright OMO sales. Instead, we expect the RBI to let natural stabilizers like increased credit offtake and higher CIC etc. reduce the liquidity surplus.

Confidence in growth and manageable inflation to be reinstated, albeit with caution

The MPC will likely signal further confidence about the economic recovery and its growth forecast, even as the committee may caution against terms of trade economic losses due to higher global commodity/oil prices and/or a possible third wave.

On inflation, given the recent sharp downward surprises, the MPC will likely take comfort and lower the FY22 forecast, especially as Q2FY22 inflation looks to be running significantly lower than the RBI’s forecast (RBI:5.9%, Emkay:5.21%). However, the MPC will likely caution on possible volatility in food prices later in the year amid an uneven temporal rainfall distribution, retail pass-through of the recent sharp rise in oil prices, consequent high HH inflation expectations and sticky/higher core inflation amid the possible percolation of input costs to output prices.

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