Monetary Policy Review

The Reserve Bank of India left key policy rates unchanged in its bimonthly review of monetary policy. The committee voted 5-1 to keep the repo rate at 6%, with the lone dissent in favour of a rate cut.

Since November last year, inflation has remained below RBI’s target of 4%. Nevertheless RBI has been holding rates mostly steady until a rate cut in August. RBI’s key reason to hold rates steady has been that the drop in inflation this year has been on mostly transitory factors such as an unexpected drop in food prices; and therefore it is likely that in the months to come, inflation would once again rise above 4%. The current RBI forecast calls for inflation to reach 4.6% by the end of this financial year and remain close to 4.5% by end FY2019. This rise in inflation from current levels is expected to be driven by pay commission and GST effects.

While inflation has undershot previous expectations, so too has growth. The most recent GDP print of 5.7% for the June quarter was underpinned by a five year low in manufacturing growth of 1.2%. RBI follows a flexible inflation targeting framework. This suggests that with inflation close to target and weakening growth outlook, there is scope for monetary accommodation. However, RBI appears primarily guided by the risk of inflation remaining above its target than growth undershoot.

Complicating the equation is the risk of fiscal slippage. State government deficits have run high in recent years following the UDAY scheme for restructuring power sector debts. Now many states have announced farm loan waivers which may keep deficits high. The centre too has brought expenditure upfront this year to support growth that has taken the fiscal deficit for the first five months of the year to 96% of the full-year target. This means that there is the added risk of the centre not meeting its fiscal goals this year. The combined fiscal deficit (centre + states) has remained stubbornly above 6% for years now and any rise could result in inflationary pressures.

On the whole then, the RBI has indicated that it is maintaining a neutral stance to monetary policy – suggesting limited scope for rate cuts.

Benchmark 10-year G-Sec yields rose by about five basis points to 6.7%. The relatively small market reaction is indicative of the fact that the policy was largely on expected lines. Going forward it is likely that RBI will be on hold for a period of time and therefore it is likely that gilt yields too will be relatively range bound. It is interesting to note that despite much noise from macro indicators and the monetary policy committee, the 10-year yield has risen by just 20 bps since the start of the year.

Thanks to the excess liquidity introduced post-demonetisation, money yields are depressed and the call rate has been trading below the RBI repo rate. This has caused the yield curve to be the short end (up to 5 years) and relatively flat thereafter.  In the absence of a clear direction on rates, we do not see value in long bonds given the much higher duration risk. Consequently, we expect to maintain a low duration stance on our portfolios.

Investors with a medium term holding horizon should look to short and medium term funds, while those with a short-term holding period should consider liquid and ultra-short funds.

 

Sources of Data: RBI, Internal Analysis

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