Monetary Policy Review

The Reserve Bank of India’s Monetary Policy Committee left key policy rates unchanged in its policy decision today. The benchmark repo rate remains at 6.25%, where it has been since October last year.

Earlier this year in its February review, the RBI changed its policy stance from accommodative to neutral anticipating upside risks to inflation from a normalization of food prices and some risks arising from the implementation of the Goods and Services Tax. Indeed the RBI narrowed the policy corridor by lifting the reverse repo rate in April to ensure that easy liquidity did not result in too low money market rates.

Since then the evolution of inflation suggests that the earlier forecast needed revision. Food prices have remained low, and the GST rates appear to have been set so as to be non-inflationary. These have prompted a revision in RBI’s inflation forecast. Thus, while inflation was expected to hit 5% by the second half of this financial year, now RBI believes inflation will be close to 4%. Ordinarily this magnitude of inflation markdown should have led to a dovish change in monetary stance. Perhaps the lone dissent was due to the reluctance to such a change.

Since the last policy, we also got the first cut take on GDP growth for the 4th quarter FY17. Growth fell to 6.1%. More importantly the data show falling rate of growth over the past four quarters. In conjunction with weak bank credit growth and the rising NPA problem this paints a rather weak picture of the macro economy.

Back in October of last year, when RBI cut rates by 25bps, the justification offered was that in the context of economic weakness, the real rate had declined. Thus, even as the then forecast of inflation of 5% was retained, the policy rate could be cut to 6.25%. Now with inflation forecast revised down to 4%, the real policy rate is at 2.25% - way higher than what the RBI has previously maintained was the appropriate policy for “normal” macro conditions. Keeping high real rates has an impact on debt service ability of borrowers.

If inflation and growth seem to indicate lower rates, why not cut rates or change the policy stance? It appears three factors are at play:

  • The current low inflation is seen as transitory and the 4% inflation number may not be sustained beyond the current year.
  • Other measures may be more effective at resolving the NPA issue rather than rate cuts. In any case the liquidity overhang post demonetization means that the actual lending rates have fallen even without policy cuts.
  • Having just moved to neutral stance in February, it is too soon to reverse course.

 

It is therefore possible that RBI may cut rates later this year if inflation remains well-behaved. In the absence of information that shows inflation persisting at 4%, any rate cuts will be limited.

The possibility of a rate cut later in the year has been taken positively by the markets. In the immediate aftermath of the policy decision, the benchmark 10-year yield dropped by about 8 bps. A possible rate cut in the near future presents a tactical opportunity in long bonds, though for a durable trade there needs to be more than just an expected single cut.

This statement also removes the risk of a rate hike from the markets. Post the April decision to hike the reverse repo rate, fears of RBI rate hikes had begun to emerge. Today the yield curve is relatively steep from the money segment to the 3-5 years. Thereafter it is relatively flat. To make excess returns from long duration one needs to see rates coming off. But at the short end, just a no-hike scenario is sufficient.

Investors could look to move up one rung in terms of their short term exposures (e.g. from the ultra-short to short-term) to capture this opportunity. Tactically there may be opportunities in long bonds, but a durable rally here needs more evidence of structural low inflation.

Sources of Data: RBI, SEBI, Bloomberg

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