A status quo in the repo rate is nearly certain in the monetary policy committee (MPC) meeting later this week. Rather, the MPC narrative around key macro variables (eg., inflation, liquidity) will be of keen interest.

In particular, banking system liquidity witnessed a rapid tightening in recent months. Any commitment (or the absence of the same) from the Reserve Bank of India (RBI) towards providing liquidity support, will have a meaningful bearing on near term interest rate outlook.

Banking system liquidity, as measured by net LAF, slipped into deficit since September, with a deficit averaging around ₹2 trillion during December-January, in sharp contrast to a surplus of about ₹1.5 trillion in the beginning of 2023-24. Amid concerns of rising inflation during H1 of 2023-24, RBI was clearly inclined to err on the side of caution with regards to expanding its balance sheet.

Accordingly, reserve money growth remains muted (January: 6.3 per cent y-o-y). With credit growth (currently, 16.0 per cent y-o-y) outpacing deposits (12.4 per cent y-o-y) for nearly two years, the rapid widening of liquidity deficit cannot be overlooked, especially during the busy season.

Several large banks (both PSU and private sector banks) have hiked deposit rates since December – even by upto 100 basis points – despite status quo on the repo rate for 12 months. Interestingly, a large part of such rate hikes are for 6-12 months only. It possibly suggests that while policy rates are expected to start softening in about six months from now, banks prefer to be extra cautious with regards to funds in the near term.

The key question is how the RBI reacts in this situation. Despite all the above points, one notes that the current liquidity deficit is about 1 per cent of the banks’ net demand and time liabilities (NDTL) – thus, still broadly in the RBI’s preferred zone. Thus, liquidity support from RBI will likely be gradual and nuanced at present, rather than being aggressive.

A preferred option for RBI can be to extend the tenor of variable rate repo (VRR) auctions – say, up to 28 days. It will mean flexible and measured infusion of liquidity, offering banks more durable liquidity and, thereby, better control over their liquidity management efforts. Second, RBI may also prefer mopping up forex inflows – which looks promising of late – and infuse rupee liquidity. Third, the large government cash balance will likely be unwound partially by March and will be another source of liquidity for the banking system.

One expects the cash reserve ratio (CRR) to stay unchanged in the February meeting. Relaxation in CRR might be considered temporarily for 1-2 fortnights in March, only if pressure on liquidity increases severely from current levels.

It seems that the case for a change in policy stance to “neutral” from the current “withdrawal of accommodation” is stronger now and a change in the policy stance to “neutral” is a possibility even in the February MPC meeting.

Status quo for now

However, one does not expect the repo rate to be lowered quickly, say for another six months. Legroom for the repo rate from the current 6.50 per cent is limited. Also, a prudent central bank will likely refrain from a rate cut around a major political event like the general election.

In sum, it may take another six months for rate cuts to start, which will be a shallow easing cycle. The MPC may consider changing the policy stance to “neutral”. Finally, one expects liquidity support from RBI, but likely in a measured and nuanced fashion.

Amid lower-than-expected fiscal deficit and market borrowing targets from the interim Budget, liquidity support from the RBI will potentially drive bond yields further lower by March, say to 6.80 per cent for the 10-year benchmark.

The writer is Chief Economist & Head of Research in Bandhan Bank. Gaurav Mukherjee and Sudarshan Bhattacharjee provided assistance for this article. Views expressed are personal