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Markets cheer as RBI walks up growth and talks out inflation


The statement admitted the truth on inflation, called the bluff on liquidity and gave growth a gentle pat on the back asking it to chug along. It wasn’t as easy as it sounds.

Markets cheer as RBI walks up growth and talks out inflation
The RBI Monetary Policy on Friday got a hearty congratulations from all markets. The Sensex hit an all time high of 45,000, the Nifty scaled 13,250- an all time high and bond prices too ended higher. The rally was an acknowledgement that the monetary policy had managed a delicate balancing act, adroitly. The statement admitted the truth on inflation, called the bluff on liquidity and gave growth a gentle pat on the back asking it to chug along. It wasn’t as easy as it sounds.
Before going into policy, the markets were nervous: inflation has been running over 7 percent since 3 months and has been way above the mandated corridor of between 2 and 6 percent for over a year. In addition, globally, excessive money supply coupled with early economic recovery and restocking has stoked quite an inflation in commodities- metals, wheat corn even sugar. Such global moves have in the past entrenched India’s domestic inflation.
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Secondly, the tidal wave of dollar inflows chasing equity assets, is being absorbed by the RBI to prevent rupee appreciation and this in turn has increased the excess liquidity in the banking system to over Rs 8 lakh crore. In addition, nearly 5 lakh crore of maturing treasury bills has left mutual funds that held them flush with cash. And since these funds, can’t park their excess money in RBI’s reverse repo window, they are looking for a home and pushing down yields of 3- month treasury bills way below 3 percent. Together, this made the repo rate and even the reverse repo rate irrelevant.
Thirdly, currency in circulation too has been growing at double the normal pace. It grew by Rs 3.2 lakh crore April to September, vs Rs 1.2 lakh crore in the same period last year. The worry was all this liquidity can act as paraffin wax to the fire of inflation. And yet any indication of reducing liquidity could scare bond markets and push up yields thus endangering the unfinished government borrowing program. As well economic recovery is still fragile requiring the aid of benign rates.
The monetary policy statement and the governor's press conference managed these contradictions with elan. It left rates unchanged and almost admitted there won’t be scope for further rate cuts. RBI deputy governor Michael Patra read out the relevant portion from the statement, "The MPC is of the view that inflation is likely to remain elevated, barring transient relief in the winter months from prices of perishables. This constrains monetary policy at the current juncture from using the space available to act in support of growth. At the same time, the signs of recovery are far from being broad-based and are dependent on sustained policy support. A small window is available for proactive supply management strategies to break the inflation spiral being fuelled by supply chain disruptions, excessive margins and indirect taxes. "
The learned deputy governor almost admitted that the space available is for supply management, not for rate cuts.
What about liquidity and the mischief it can create. The RBI correctly diagnosed that there may be no need to take extraordinary action to pull up short term rates to the level of the reverse repo. In the fullness of time, banks can borrow in the TREPs ( the overnight repo market where mutual funds can also lend) and park in reverse repo making a cool risk free 35 bps, The buzz is RBI is already calling up some banks to iron out the anomaly in short term rates.
Has RBI junked inflation targeting? Or has it a least given up the 4 percent mid point and will be tolerant of 4.5-5 percent inflation? "We are battling a one-in-a-century event," said the governor in reply, The market clearly gave him the benefit of doubt.
Net net, RBI saw through the excess liquidity issue, acknowledged inflation and boldly admitted it is taking the risk in favour of growth. "Monetary policy will monitor closely all threats to price stability to anchor broader macroeconomic and financial stability," about summed up its reassurance.
Will next year or even next policy be tougher? Will RBI be forced to roll back liquidity sooner or later and will that upset next years borrowing? Not necessarily. If RBI can manage keeping Rs 8 lakh crore surplus when inflation is as 7.5 percent, it should manage when inflation falls to 6 percent and then to 5 percent. As well, next year, tax collections should be better and hence the government borrowing, lower. From all accounts, RBI has walked and talked through a tough period with flying colours.
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