Monetary Policy Committee meeting: 3 key issues for deliberation before the 6 wise men to agree and disagree

The six-member Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI) is expected to deliberate on the three key issues—signals from the US Federal Reserve, narrowing the repo and reverse repo corridor, and reducing the quantum of surplus liquidity in the system. The MPC sets the interest rates in the country by keeping a watch on inflation and supporting the growth.     One of the MPC members, Jayanth R. Varma of the Indian Institute of Management, Ahmedabad, has already made a case for gradual reduction of the policy rate corridor, which is currently at 65 basis points. Another outside member Dr. Ashima Goyal, professor at Indira Gandhi Institute of Development Research, had also suggested monetary policy normalisation even in an accommodative stance (easy liquidity conditions). The other members of the MPC include Shashanka Bhide, senior advisor at the National Council of Applied Economic Research, and three RBI representatives— Mridul K. Saggar, executive director; Michael Debabrata Patra, deputy governor; and governor Shaktikanta Das, who is also the chairman of the committee.     The MPC, which will announce its decision on October 8, is expected to continue with the accommodative stance with the status quo in repo rate at 4 per cent to support the recovery in the economy. There is also no change expected in the projections for GDP and inflation in the current fiscal. The RBI's projection for GDP growth stands at 9.5 per cent, whereas the Consumer Price Index (CPI), or retail inflation, is forecasted to be around 5.7 per cent in 2021-22. So let's look at the three critical areas where the MPC members may differ:  Start preparing for the US Federal Reserve’s exit from the easy monetary policy     A fortnight ago, the US Federal Reserve had given signals of slowing down the asset purchases (creating liquidity by buying bonds) and had also hinted at a possible interest rate hike in the near future. The Fed rate, which is a short-term rate like the repo rate, is currently at the near-zero level. There is now a certainty of reversal of easy monetary policy globally, which means a tighter monetary policy in the near future. Experts are already factoring in the certainty for US Fed tapering starting post-November this year and interest rate hikes post-June-July next year. The emerging-markets, including India, have to prepare for the likely outflow of dollars and its impact in their financial markets. Globally, there are central banks like Mexico, Brazil, and Colombia that have started hiking the interest rates because of inflation fears. 

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"Some global factors, such as a crude price hike due to shortages in China and the UK, and the Federal Reserve indicating that it is likely to begin tapering by the end of the year could cause volatility, " said Shanti Ekambaram, Group President – Consumer Banking, Kotak Mahindra Bank Ltd.     In an uncertain environment where inflation is averaging 6 per cent for the last two years, the easy monetary policy for a prolonged period will act as fuel to the (inflation) fire.  Narrowing repo and reverse repo rate band in a gradual manner     The reverse repo rate, the rate at which RBI absorbs surplus liquidity from banks, is currently kept low at 3.35 per cent. The difference or the corridor between the repo rate (4 per cent ) and reverse repo rate is currently at 65 basis points. This difference used to be 25 basis points during the pre-Covid-19 period or during the normal periods. In the post-Covid-19 period, the RBI had to widen the gap in order to discourage banks from parking surplus money with the central bank. This was done to support the financial system. In fact, the reverse repo rate became the operating rate in the market for over a year because of RBI's accommodative stance or surplus liquidity policy.   In the last MPC meeting in August, one of the MPC members, Jayanth Varma had said that a gradual normalisation of the width of the corridor is warranted. "In my view, a phased normalisation of the corridor would increase the ability of the MPC to keep the repo rate at 4 per cent for a longer period, and this should, in my view, be a greater priority for the MPC than maintaining an ultra-low reverse repo rate for some more time," Varma said. The MPC mandate, however, is restricted to repo rate and doesn't extend to the reverse repo rate. "The RBI may change the forward guidance somewhat to prepare for a reverse repo rate hike by December policy," said Pankaj Pathak, fund manager at Quantum Mutual Fund.  Lowering liquidity levels in a calibrated manner     In the last two years, the RBI has moved from liquidity 'deficit' in the system to the 'surplus' mode to support the economy. There was a demand from the industry for an accommodative stance post the debacle of IL&FS. The monetary conditions were very tight some two years ago. The pandemic has further boosted the liquidity levels in the system as RBI came out with several schemes to infuse liquidity. 

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Currently, the daily surplus liquidity is in the region of Rs 10-12 lakh crore. There is also a cost attached to it as RBI absorbs this liquidity by paying banks at 3.35 per cent. One of the MPC members Goyal had said that whenever monetary normalisation starts, it should be very gradual and aligned to growth recovery and inflation paths.     "Since stance affects only repo rate actions, other normalisation can start even in an accommodative stance," said Goyal. In the post-global financial crisis, the RBI had decided to first reduce excess liquidity before taking a call on interest rates.  Similarly, the US Federal Reserve had decided to halt its balance sheet expansion, which increased from a trillion-dollar before the Lehman crisis to over 5 trillion dollars by 2013-14, but the US central bank didn't reduce the balance sheet size back to the pre-crisis level. M Govinda Rao, Chief Economic Advisor of Brickwork Ratings said that the RBI may signal the mopping of excess liquidity, although the actual mopping up will be done in a calibrated manner.