Srei Blog Understanding the outcomes of RBI's Monetary Policy

RBI cut the Repo and Reverse Repo rates to 6.00% and 5.75% respectively, with 4 members out of 6 voting for a 25 bps rate cut. RBI reiterated neutral monetary policy stance and comments that the trajectory of inflation is expected to rise from current lower readings. RBI said that it is focused on its commitment to keep headline inflation close to 4% for FY18. RBI stated that the trajectory of baseline inflation remains uncertain owing to the impact of price revisions ahead of GST and impact of implementation of HRA scheme under 7th Central Pay Commission. RBI further stated that they expect GDP growth for FY18 at 7.3% and that although outlook for agriculture remains robust, underlying growth impulses in industry and services are weakening. The statement on development and regulatory policies also noted that the MCLR framework needed to be refined so as to make bank rates more sensitive to funding costs, possibly to floating rate benchmarks. It also promised a final circular on corporate bond tripartite repo in mid—Aug, easier hedging, a separate limit in interest rate futures so FPIs could hedge purchases in bonds when limits were unavailable, and a broadening of the coverage of household surveys. The stock market reacted negatively to the rate cut, as bank stocks witnessed a sell-off post RBI’s policy. With the RBI maintaining its neutral stance and flagging other upside risks to inflation, rate sensitive sectors such as automobile, reality and other non-banking financial sectors also faced losses. Shares related to energy sector saw gains following higher than expected earnings reports from energy majors. The following points were dealt at length in the policy Inflation: RBI acknowledged that food inflation has been under check amid normal monsoon and effective supply management by the government. Other factors such as falling core inflation and stable global commodity prices have also helped. However, the Committee expects inflation to move towards the higher range of 3.5-4.5% in second half of the year from 2.0-3.5% in the first half. The pickup in inflation is primarily on account of fading base effect, impact of house rent allowance under the 7th Pay Commission etc. The pickup in vegetables inflation is another cause for concern. Besides, the implementation of the farm loan waivers by states and the timing of the HRA pay-out by the states are key moving variables. RBI expects 100 bps rise in headline inflation over the next 18 – 24 months on account of states’ HRA implementation. The RBI acknowledged that previously expected upside risks to the baseline inflation path had not in fact materialized and in the absence of HRA impact the Q42018 inflation outcome could well have been lower than 4%. Overall RBI’s outlook for inflation is balanced and closes the expectation gap with the market. Growth: While the GVA growth projection for FY 2018 has been left unchanged at 7.3% the Committee noted that the sentiment for the manufacturing sector remains low. RBI continues to flag high leverage at the corporate sector as the key impediment to private investment while the farm loan waiver has the potential to crowd out capital expenditure. Meanwhile from a medium term perspective, GST is expected to boost growth on account of the shift from unorganized to organize sector and synergies in the domestic supply chain. Beyond the low inflation trajectory, the widening of negative output gap opened the space for today’s easing. Liquidity: The surplus liquidity continues to persist amid front loading of government expenditure. The proposed extension in the market stabilization scheme (MSS) limit from INR 1 tn to INR 2.5 tn is expected to limit the OMO sale beyond the one announced of INR 100 bn to be conducted on August 10th. High real interest rate: High real interest rate, which has been crucial in bringing down inflation expectations, has the potential to hurt the fragile nature of economic recovery. As an aside, higher real interest rates attract strong capital inflows, putting undue pressure on the currency to appreciate. Along with low demand and rising protectionism globally, exports performance could be adversely affected by a stronger currency. Further policy easing to be data dependent While the argument for further rate cut is still valid, any such move will be strictly data dependent. RBI maintaining the neutral stance and reiterating the need to keep headline close to 4% on a durable basis suggests that undershooting of the latest inflation projection is crucial for further action. While the HRA hikes by the Centre and states is transitory, farm loan waivers can result in inflation spill over. Given the elections scheduled in Gujarat, Rajasthan, Madhya Pradesh and Chhattisgarh over the next one year more such announcements might be expected. One has to watch evolving data prints to determine the possibility of further action but at the moment space seems limited. Development and regulatory measures: Improvement in Monetary Policy Transmission: An internal Study Group has been constituted by the Reserve Bank of India (RBI) to help improve the monetary transmission and exploring linking of the bank lending rates directly to market determined benchmarks. Separate limit of Interest Rate Futures (IRFs) for Foreign Portfolio Investors (FPIs) to the tune of INR 5000 crore. Amendment to Liquidity Coverage Ratio (LCR): Excess reserves held with the foreign central banks to be recognized as the high quality liquid assets (HQLA). Tri-party repo: to be introduced by mid-August to improve liquidity in the corporate debt market.