The Reserve Bank of India used some stealth to nudge short-term interest rates higher at its August Monetary Policy Committee meeting, although it left its main signaling tool, the repo rate, unchanged at 6.50%.

In a justifiably hawkish statement, the RBI raised its inflation forecast due to high food prices, dashing all hope of a pivot to interest rate cuts in the current financial year.

The RBI imposed an incremental cash reserve ratio of 10% on banks for deposits accrued between May 19 and July 28. This measure is bound to drive up short-term interest rates from Aug 12, when the action takes effect.

RBI Governor Shaktikanta Das said this measure is temporary, and liquidity will be released before the festival season kicks in late September or early October. But in the same vein, he also told the media that incremental CRR can be taken as a non-interest rate measure to tame inflation.

The market, which expected even more hawkish policy, perhaps even an interest rate hike, took comfort that overall policy was not as bad as was feared.

Hawkish Pause

The RBI’s MPC left the policy repo rate unchanged with a 6-0 vote. It retained the stance of withdrawal of accommodation with a 5:1 vote.

As has been the case, external member Jayant Verma did not support the wording of the stance.

Other key aspects of the MPC statement were:

• · GDP forecast for FY24 was retained at 6.5%, with risks evenly balanced. The GDP growth in the first quarter of FY25 is projected at 6.6%.
• · Forecast for FY24 inflation was raised to 5.4% from 5.1%. Importantly, the forecast for the first quarter of the next financial year was set at 5.2%.

Interestingly, a key difference between August's statement and the one for July is the subtle escalation in the hawkishness on the part of the governor by leaning again on the epic Mahabharata.

“We have to stand in readiness to go ‘beyond keeping Arjuna’s eye’ to deploying policy instruments, if necessary,” Das said in his statement. In the previous statement, he merely wanted to maintain “Arjuna’s eye” on the evolving inflation scenario.

Tightness By Stealth

Outside of the MPC resolution, the RBI imposed incremental CRR to temporarily impound liquidity.

The last time the RBI used this instrument was in 2016 when it looked to impound liquidity that resulted from the government’s demonetisation drive.

Das said the RBI considered all available instruments and chose incremental CRR because of the surge in liquidity surplus due to the withdrawal of the 2,000-rupee notes from circulation. CRR is not a part of the RBI’s usual arsenal for liquidity management. RBI drains durable liquidity through long-term reverse repos, FX swap auctions, or open market operations.

In a different context, he said the RBI is worried about inflation, and the imposition of the incremental CRR was an effort to tackle inflation.

Lately, the liquidity surplus has also risen due to substantial foreign portfolio investments, RBI’s dividend to the government, and a surge in government spending.

Even if liquidity tightens due to the usual festival-related currency leakage, such an event could be temporary. It would force the RBI to undertake a stronger measure to drain out liquidity. To that extent, RBI could use more tools to tighten liquidity and drive-up short-term interest rates.

In other words, even if the RBI does not raise interest rates through the repo, it will through the liquidity channel to control inflation.

The markets will slowly recognise this aspect and factor it in.

Governor Das was also non-committal on the extent of surplus liquidity tolerable for the central bank. Das said there is no fixed formula, and the extent of tolerable surplus liquidity is a variable that depends on prospects for growth and inflation.

Post Diwali, the RBI could deploy more robust measures to drain liquidity to bring down inflation closer to 4% and, in the interim, anchor inflationary expectations. Even on inflation, Das said the RBI, for now, is seeing through the impact of food inflation. And such benign neglect can work only up to a certain point.

Another important takeaway from the August MPC review is that monetary transmission needs to catch up. Das noted that during COVID, the RBI cut the repo rate by 250 basis points. During that time, the weighted average domestic term deposit rate on fresh deposits and the weighted average lending rate on fresh loans had fallen by 259 basis points and 232 basis points, respectively.

And, when the RBI has hiked interest rates by 250 basis points in the current cycle, the increase in the average deposit and lending rates has been only 231 and 169 basis points, respectively. The hiking cycle transmission trails the easing cycle, Das said. The RBI may look to hasten this process with its liquidity measures.

The market has taken the RBI policy in its stride. The coming days could be different. The market could realise that the fine print does show that the central bank is relatively hawkish, the inflation outlook is uncertain, and rate hikes are back on the table in October.

Moreover, the RBI could make efforts to tighten liquidity. Those praying for interest rate cuts will have to pray longer and stronger as the RBI seems to have pledged to keep the rates higher for longer.