The Reserve Bank of India’s (RBI) inflation mandate has likely reinforced the push to drain excess liquidity, with the odds of a rate hike at the October meeting on the rise, according to economists.
Short-end rates are likely to stay bid as markets price in these rate increases, they added.
According to Radhika Rao, Senior Economist and Executive Director, DBS Bank, pullback in benchmark oil prices helped to stabilise INR asset markets, though overnight climb in US yields might counteract some of the positive impact.
“USD/INR had ended around the mid-95 handle, though is set to resume its climb, attracting strong intervention bids. Liquidity conditions have tightened meaningfully following the central bank’s sustained absorption operations, which have relied on a mix of open market operations, VRRR auctions, and short-tenor sell-buy swaps,” she explained.
Tax outflows, rising seasonal currency leakage, and intermittent FX sales likely helped further lower the surfeit.
As a result, the liquidity balance narrowed to below Rs 5 lakh crore last week from a peak of around Rs 10-11 lakh crore, helping to improve monetary policy transmission and align the weighted average call rate more closely with the repo rate.
Liquidity and core inflation have historically displayed a modest positive relationship, said the economist.
Pranjul Bhandari, Chief India Economist and Strategist, HSBC Global Investment Research, said that they maintain the long-held view of two 25 bp hikes in the October and December meetings, respectively, taking the repo rate to 5.75 per cent.
“We also expect further clarity/steps on liquidity removal in the October meeting,” she noted.
Excess liquidity can quickly become inflationary and can raise financial stability risks if banks become dependent on abundant liquidity.
The RBI has already deployed VRRRs, OMO sales, and FX swaps/spot sales. CRR hikes and MSS issuance are options under consideration.
