Monetary tightening behind us; liquidity to remain key focus for RBI

After the RBI MPC paused monetary tightening in April 2023, although attempting to reinforce that the pivot is way off, the markets are bracing for the onset of the rate cuts sooner rather than later. The softer than expected inflation (particularly the recent moderation seen in the seasonally adjusted core inflation), above 1% real policy rates, easing external balance pressures along with global monetary tightening hitting its peak have been indicating that the MPC could be aligning in favor of a dovish tilt. However, we expect them to remain wary of the uncertainties associated with the monsoons and oil prices, especially as growth remains resilient.

Furthermore, while the Fed fund futures is pricing in 50bps of rate cuts in CY2023 (lower than 75bps being priced in a week ago), we expect a pause by the Fed (given our expectation of a soft landing) which in turn may become a cause of volatility in the markets. We thus continue to expect that while the need for further rate hikes remains minimal, the RBI MPC should maintain a pause through FY24.

In fact, the cautious approach by the RBI can be inferred by the persistence of overnight rates around the upper end of the LAF corridor over the past month with announcement of variable rate repo (VRR) coming about only recently. Barring the recent easing in rates this week, overnight MIBOR has averaged 6.80% over the past month. The pressure has been led by a combination of tightening in the system liquidity and its skewed distribution. Much of the drainage in the liquidity surplus through 2023 has happened due to higher currency in circulation (CIC). On the other hand, favoring liquidity conditions lately has been the increase in the government spending along with RBI FX intervention (although more lately we are witnessing liquidity withdrawal due to USD sales which in turn may have prompted the RBI in providing for the VRR).

Given the recent trends of aggressive spending by the government, the liquidity conditions may ease further in the coming weeks as bulky receipts from RBI dividend, GST collections and advance tax are spent entirely. These expectations have clearly been priced in at the shorter end of the curve, where the rates have crashed significantly. The overnight MIBOR has fallen nearly 50bps from a peak of 6.90% a week ago. The 3-month T-bills are trading near 6.73% currently compared to last week’s auction cut-off of 6.94%. However, the recent global risk-off weighing on INR may prompt RBI into aggressive USD sales thereby offsetting the easing conditions.

We expect liquidity conditions to ease further in 2QFY24 amid seasonal payback in CIC with the government likely to keep the spending trends on. Further, RBI’s persistent intent to opportunistically buffer up FX reserves could also help in aiding liquidity. Notably, RBI also has a net long forward outstanding book worth US$24bn. However, 2HFY24 is expected to see liquidity conditions tighten yet again amid seasonally higher CIC leakage and as frontloaded government spending may have run its steam. The sharp fall in the overnight rates seen lately towards the SDF rate should not sustain and instead should revert towards the higher end of the LAF corridor unless RBIs intervenes in 2HFY24.

With the rate hikes behind us, the focus clearly will be on how RBI would manage the liquidity conditions in the system and the policy stance. More so, the question is whether RBI would prefer to keep liquidity tight to rein and anchor inflationary expectations. In that case the operating target rate being maintained higher than Repo rate seems more like an intended action and not coincidental.

We expect the RBI to manage frictional liquidity through periodic VRRs in the near term (RBI may consider using different tenures). Any durable infusion of liquidity (through CRR cuts or OMO purchases) can come about only after the shift in the policy stance away from ‘withdrawal of accommodation’ to ‘neutral’. We expect the RBI MPC to use the next two meetings to begin tweaking the language for policy stance towards neutral (staying short of being entirely neutral in the June policy and a clear shift towards neutral by the August policy). Following these changes, we assign a high probability of a CRR cut of 50bps in 3QFY24 to ease the structural drain on liquidity.The author is the Chief Economist of Kotak Mahindra Bank. The views and opinion expressed in the column are personal and do not necessarily reflect the opinion of the organisation or the Kotak group.