Decoding today's policy status quo: The factors at play behind RBI's rate decision

MUMBAI: The Reserve Bank of India’s primary tool to fuel economic recovery will be to ensure surplus liquidity in the system that would keep market interest rates low well into the next year as rising inflation forced it to keep policy interest rates unchanged.
It persisted with accommodative stance to provide support to a fragile economic recovery that still has many segments limping while raising its economic forecast to a contraction of 7.5 percent for this fiscal, from 9.5 percent earlier. CPI inflation projection for the first half of next fiscal is raised to a range of 5.2 to 4.6 percent from 4.3 percent forecast for the first fiscal quarter.

As the excess liquidity seeps through the financial system to the economy, the central bank is raising the game on financial stability by barring dividend payouts by banks for last fiscal. The Monetary Policy Committee voted unanimously to keep rates unchanged and maintain the accommodative stance.

"The signs of recovery are far from being broad-based and are dependent on sustained policy support," Governor Shaktikanta Das said. "Inflation is likely to remain elevated, with some relief in the winter months from prices of perishables and bumper kharif arrivals. This constrains monetary policy at the current juncture from using the space available to act in support of growth."

Repo rate, the rate at which it lends to banks is kept at 4 percent while the reverse repo rate, the rate it pays banks for keeping surplus funds with it, at 3.35 percent.

All other rates remain unchanged.

"The RBI resisted blinking despite the high inflation glare," said Aurodeep Nandi, economist at Nomura Securities. "The RBI has essentially doubled down on its October accommodative guidance and asserted that inflation remains largely supply side driven and that supporting growth remains its paramount priority."

Financial markets cheered the decisions with the benchmark bond yields falling 2 basis points to 5.90 percent, and the Sensex racing to a record high of 45,033.19.

The RBI got into synchronized easing of monetary policy with global central banks to fight the collapse of economic activity due to Covid-19 triggered lockdown. It pumped in record amount of liquidity through bond purchases, intervention in the foreign exchange market and targeted lending to industry through long term repo operations.

But unlike the developed markets, India faces the threat of inflation which has run above the targeted 2 to 6 per cent band for several months. In October CPI climbed 7.6 percent, highest since May 2014. While the MPC has maintained that it is transient, the all-round rise in commodity prices and sticky product prices are a threat to the prevailing monetary policy.

The central bank while keeping rates unchanged is influencing the financial markets with excess liquidity. With the system liquidity in surplus of nearly Rs 8 lakh crores, market rates are below policy rates.

"The absence of any major liquidity absorption measures in the midst of a prolonged inflationary episode and indeed the upward revision of both the RBI’s growth and inflation forecasts might be somewhat puzzling," said Abheek Barua, economist at HDFC Bank. "It could mean that the RBI is still cautious about the durability of growth and it is willing to tolerate higher inflation as long as growth impulses become firmly entrenched."

Although Governor Das promised to keep the financial markets well-funded to keep interest rates low, he signaled he would not hesitate to bring out tools such as Market Stabilisation Scheme or the Standing Deposit Facility to prevent overheating of the market.

"We will continue to respond to global spillovers in order to secure domestic stability with our liquidity management operations," said Das. "The various instruments at our command will be used at the appropriate time, calibrating them to ensure that ample liquidity is available to the system."