Monetary Policy Review

The Monetary Policy Committee of the Reserve Bank of India cut the benchmark repo rate by 25 basis points to 6% in today’s review. This reduction was in line with market expectations as reflected by the subsequent muted reaction by the bond market.

Falling food price inflation has been the story of the year. The most recent read indicates food price deflation and the headline Consumer Price Index inflation dropped to a new low of 1.5% in June. What is more note-worthy is that non-food, non-fuel (a measure of core inflation) has also dropped consistently over the past three months to 4%. The persistent undershoot of headline inflation and a moderation of core inflation to RBI’s target of 4% has given the central bank room to cut rates.

To be sure, some of this fall in food prices could reverse in the coming months. In particular prices of pulses and vegetables have fallen by over 15% compared to last year. It is unlikely that this pace of fall can be sustained. It is much more likely that inflation would revert closer to the 4% level – that is, closer to the core reading. Even achieving a 4% inflation rate by the end of the current year would be a big win for RBI.

Disinflation has been accompanied by a slowdown in growth – in particular in the manufacturing sector. Some of this could be as a (lagged) result of demonetization last year. However as the GDP report showed in May, the pace of growth has been falling in each of the past four quarters.

Lower growth and lower inflation together make a strong case for a rate cut. But even as the current conditions argue for a strong monetary response, the RBI believes that the near term outlook is clouded. As explained above it is likely that we have seen the trough of inflation. On the growth front, the impact of a rate cut on growth might be limited – as some of the slowdown in growth is due to weak balance sheets of banks and the corporate sector. A reduction in interest rate may not spur lending activity in such a situation.

The overall macro situation is also supported by easy liquidity and an accommodative fiscal stance. The pace of remonetization has slowed in recent months and excess liquidity appears to be persistent. This has been supported by strong FPI flows. On the fiscal front, we have seen the central government hit 80% of its budgeted deficit target in the first quarter itself. Several states have announced farm loan waivers which could result in fiscal expansion.

On balance therefore the RBI has opted to cut rates, but has maintained a neutral stance of policy – preferring to wait for further data to decide if rates should be further reduced.

In the near term we expect the markets to remain range-bound. There may be tactical opportunities in long duration bonds from time to time, though from a structural perspective it does appear that we are very close to the end of the rate cycle. At the same time easy liquidity has depressed money market yields. In such a situation investors should consider short-term corporate bond funds, which are relatively insulated from duration risks but take advantage of the steep short term yield curve.

 

Sources of Data: RBI, Internal Analysis

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