RBI seizes its last opportunity


The run-up to this policy was interesting in the way one-sided bets on a rate reduction by the Reserve Bank of India (RBI) had built up. No doubt, headline consumer price index (CPI) inflation had slowed from 3.9% in March to 2.2% in May and more critically to 1.54% in June, below the lower end of RBI’s first-half projection of 2-3.5%. Further, market hopes were raised by the fact that core inflation, which excludes food and fuel prices, came in at 3.8% for June, breaking below the crucial barrier of 4%. RBI had consistently cited stickiness in core inflation at above 4% as a factor that deterred confidence that the headline CPI inflation would be anchored at the 4% level—the RBI’s target.

The factors that are likely to have swung the RBI towards a rate cut in this policy, are that some of the upside risks to inflation have diminished or have not materialized. Monsoon rains are favourable, early fears of weak pulse sowing have receded and international commodity prices are stable.

Technically speaking, the baseline projection of inflation excluding the housing rent allowance impact from the pay commission recommendations is now lower than the projections made in June and is just a shade above 4%. This is possibly the reason why RBI made a “calibrated move” at an “opportune time”—as explained by governor Urjit Patel at the post-policy press conference.

However, RBI continues to maintain caution on the future path of inflation. It clearly indicates that even as headline CPI inflation has fallen to a historic low, there is no clarity yet on the mix of factors that could have caused it—namely factors that are transitory and those that are more structural. Further, RBI is aware of the fact that with the base effect fading away, inflation is anyways likely to move higher. Add to this is the worry that farm loan waivers by states may result in fiscal slippages and could lead to inflationary pressures in the future. Inflation might also be pushed up by the fact that states might soon implement their own pay increases in lines with the Central Pay Commission recommendations. As per RBI estimates this might have the potential of adding another 100 basis points to headline inflation.

Thus, with such inflation risks on the horizon, there is no way RBI could have moved away from its “neutral” stance on monetary policy. In this sense, RBI is clearly hesitant to hold out much hope for the market of deeper rate cuts. We also think that there is a realistic chance of no further dip in the repo rate in the next 6-8 months at least. The bond markets therefore failed to exhibit much joy out of this rate cut and the 10-year benchmark yield closed higher post the policy announcement.

Going ahead, there is a strong expectation for global liquidity to shrink—as the Fed and also the European Central Bank talk of reducing their balance sheets. The realignment of liquidity between the emerging markets and the developed markets is a factor that is unknown and could hold out some risks for the domestic bond yields to increase. Liquidity is also likely to get squeezed hereon, with a possible increase in the market stabilization scheme (MSS) limits and also RBI continuing to suck out liquidity via the open market operation (OMO) sale of securities. Our internal calculations indicate that RBI could incrementally be seen to conduct another Rs70,000 crore-Rs. 1 trillion of OMOs to neutralize the liquidity mainly coming through foreign flows.

Overall, we thus see the bull phase of the bond markets to be largely over and factor in a steepening bias to the curve. The 10-year benchmark yield could therefore remain in a range of 6.40-6.75% in the remaining part of the year.

But would the rate cut help the real economy? We do not think so and lending from the banking sector to the real sector is unlikely to improve dramatically. This is because the demand side dynamics are yet not positive in a way that the private sector starts to invest. Capacity utilization in the economy broadly continues to languish at a 70-72%. Fear is also that this latest rate cut might not translate into any meaningful drop in the marginal cost of funds-based lending rate (MCLR). Thus the more important area that RBI seeks to tackle is the issue of transmission of monetary policy. It says that MCLR, introduced to improve the monetary policy transmission, has not been “entirely satisfactory”. RBI has thus instituted a study group with the perspective of improving monetary policy transmission and also to explore linking of the bank lending rates directly to market-determined benchmarks. While this might be a thought in the right direction and could be helpful in developing the term interest rate curve, implementation of the same can take time.