Risk to the inflation outlook stems from the liquidity overhang in the banking system: RBI

Inflation woes were largely due to supply-side issues. The members showed cautious optimism, leaning towards incoming data, to determine the rate trajectory. Image: Danish Siddiqui / Reuters
 
Inflation took centerstage when the Reserve Bank’s rate-setting panel met earlier this month. The minutes of the meeting held from August 8-10 suggest a rate cut is unlikely this year. Jayanth Varma, Monetary Policy Committee member, said, “In June, I warned against declaring victory based on the inflation prints of just a couple of months, and expressed discomfort with the self-congratulatory tone of the MPC statement of that month about inflation having come inside the tolerance band. It is now clear that we would have a couple of months of inflation readings well above the tolerance band.”
 

Inflation woes were largely due to supply-side issues. The members showed cautious optimism, leaning towards incoming data, to determine the rate trajectory. But there were a few differences on how they expected inflation risks to play out in the coming months. For example, MPC member Ashima Goyal argued that a second-round impact of food inflation is unlikely since core inflation and pass-through of input costs is expected to ease further, but RBI’s deputy governor, Michael Patra, feared the imbalances in food prices could trigger a second-round effect and put pressure on overall price levels of goods and services.
 
In the August meeting, Rajiv Ranjan, executive director, RBI, stated that the forecast of the continuation of uneven monsoon in the next two months combined with an El Nino event, amid global food prices, clouded the outlook on food prices. But he added that the monetary policy can’t do much to stem the first-round effect of a supply side shock from vegetables, for example.
 
“If monetary policy responds to such a surge in headline inflation, the policy would likely be excessively tight and induce high volatility in macroeconomic conditions. On the other hand, if these shocks do not go away and become persistent then inflation expectations can become unanchored, leading to a drift in inflation away from its underlying trend. It may be noted that on the earlier two occasions, during mid-2020 and during mid-2021, the MPC’s prognosis of looking through transitory pressures on inflation has in fact proved accurate,” Ranjan asserted.

Also read: If price shocks persist, we have to act: RBI
 
MPC member Shashanka Bhide, according to the minutes, expressed concerns of broadening price pressures and downside risks to GDP growth.
 
“While there is a moderating trend in the headline inflation rate, there are clearly upside risks on account of the weather uncertainty affecting agricultural prices. The international commodity prices have remained low in 2023 relative to the peaks of 2022; however, the volatility has increased for some of the agricultural commodities and there is hardening in the case of energy in the recent period. While the spikes in prices of a few commodities may not lead to persistent overall price pressures, broadening of price pressures would be a concern. There are also risks to growth projections, particularly as they relate to export demand. Therefore, there is a need at this juncture to retain the current policy rate and the policy stance to sustain the moderating forces on inflation,” Bhide cautioned.
 
MPC member Jayanth Varma believes that the repo rate at 6.5 percent is high enough to bring inflation below the upper tolerance band (6 percent) on a sustained basis and also glide it towards the middle of the band (4 percent).
 
“I view these monthly gyrations with some degree of equanimity. Just as a couple of low readings do not call for celebration, it is equally true that a couple of very high readings do not call for panic. What is important is the projected trajectory of inflation over the next several quarters. On this basis, I continue to have the same cautious optimism that I had in the June meeting. I expect the continuing slowdown in China to keep a lid on commodity prices. Moreover, rains in July have attenuated the monsoon risks, though there are continuing worries about the spatio-temporal distribution,” Varma said to assuage inflation fears.
 
Importantly, Patra sounded the alarm bells on the surplus liquidity in the banking system. “A risk to the inflation outlook stems from the liquidity overhang in the banking system. Withdrawal of excess liquidity should engage primacy in the attention of the RBI going forward as it presents a direct threat to the RBI/MPC resolve to align India’s inflation with the target, besides the potential risks to financial stability,” he warned.
 
In an unexpected move, on August 10, RBI announced a temporary imposition of incremental cash reserve ratio (ICRR) of 10 percent on NDTL (net demand and time liabilities), for the period of May 19 to July 28, to absorb excess liquidity in the system, in a non-disruptive way, to tackle the surge in bank deposits following the central bank’s decision to withdraw Rs 2,000 currency notes from circulation. As of July 31, about 88 percent or Rs 3.14 lakh crore has been deposited in banks. Pankaj Pathak, fund manager-fixed income, Quantum AMC, believes that despite the 10 percent ICRR, the banking system liquidity is likely to remain in surplus of more than Rs 1 lakh crore for the next one or two months.  
 
RBI Governor Shaktikanta Das said the central bank’s liquidity management has been nimble. “We will manage the liquidity overhang proactively using the various instruments at our command while ensuring that the banking system has adequate liquidity to meet the productive requirements of the economy,” he said to address concerns.
 
Goyal agreed there was a need for monetary policy to signal continuing watchfulness to manage excess liquidity in the system and align inflation with the 4 percent target. “Since global inflation is moderating without a major impact on growth a soft landing becomes more feasible. But financial fragilities in some countries, erratic weather and geopolitics continue to remain threats. The progress of the rest of the monsoon, possible supply-side action, further pass-through of past rate hikes, the behaviour of food prices and the evolution of core inflation, have all to be carefully observed,” she added.

Also read: Reserve Bank's Monetary Policy Committee likely to hold rates in August
 
Headline inflation rose from 4.3 percent in May to 4.8 percent in June and to a 15-month high of 7.4 percent in July. The pick-up in inflation is largely on account of higher prices of vegetables, eggs, meat, fish, cereals, pulses and spices. Overall, core inflation was stable. The central bank is worried that the spike in vegetable prices—led by tomatoes—will add upside pressures on the near-term trajectory of retail inflation. But it is hopeful that fresh market arrivals of fruits and vegetables will ease price pressures. The improvement in the progress of monsoon and kharif sowing could help to cool prices to some extent. Furthermore, the outlook for crude oil prices is unclear given the possibility of production cuts by some OPEC members.
 
On August 10, the Monetary Policy Committee announced its decision to keep the repo rate unchanged at 6.5 percent for the third time in a row. Other than Jayanth Varma, all members voted to remain focussed on withdrawal of accommodation to align inflation to the target of 4 percent while supporting durable growth in the economy. Importantly, the central bank raised its inflation outlook for the July-September quarter to 6.2 percent from 5.2 percent earlier—signalling that the war against inflation is not over and interest rates may be higher for longer. It retained its growth estimate at 6.5 percent for FY24.   
 
Governor Das cautioned that headline inflation is likely to witness a spike in the near term on account of supply disruptions due to adverse weather conditions. “It is important to be vigilant about these shocks with a readiness to act appropriately so as to ensure that their effects on the general level of prices do not persist. There are risks from the impact of the skewed south-west monsoon so far, a possible El Niño event and upward pressures on global food prices due to geopolitical hostilities,” he explained.