Monetary Policy Review – August - 2017
RBI's Monetary Policy Committee reduced the repo rate by 25bps to 6%, as widely expected, but maintained its policy stance as Neutral. It re-iterated its objective of achieving the medium target of CPI inflation of 4% within the band of + / - 2%, while supporting growth.
It cited the recent fall in inflation (CPI) and non-materialisation of some of the risks identified in previous policies - expected inflation for Q4 2017-18 has fallen below earlier projections, GST roll-out has been smooth, inflation excluding food and fuel has fallen significantly over the last three months and normal monsoon (thus far). It also noted that inflation is expected to inch up to a range of 3.5% to 4.5% in the second half of the year as the base effect (which helped bring inflation down over the last few months) wears off and decided to maintain a Neutral stance.
Further, the future trajectory of inflation would be determined by the impact on CPI of the implementation of house rent allowances (or HRA) under the 7th Central Pay Commission (CPC), impact of price revisions withheld ahead of GST and indications of whether the factors impacting food inflation are transitory or structural in nature. Other factors creating uncertainty around the inflation trajectory include implementation of farm loan waivers by states and possible fiscal slippages, timing of the states' implementation of salary and allowance increases similar to the Centre (a similar timing might result in a rise in headline inflation by an additional 100bps) and price pressures building in vegetables and proteins in the near months. It also cited factors that might keep inflation subdued in the near term including a normal monsoon, general moderation in core inflation (i.e. CPI excluding food and fuel) and stable outlook for international commodity prices.
Importantly, the RBI also maintained its GDP growth outlook for the current fiscal at 7.3% on expectations of a normal monsoon boosting rural demand, government spending particularly on roads and bridges and the growth enhancing effects of GST. As in recent policies, it highlighted the urgent need (for the government) to revive private investment, remove infrastructure bottlenecks and speed up implementation of the government's affordable housing scheme to sustain and boost economic growth.
Impact on the economy
Given that the rate reduction is marginal at 25bps, a boost to consumption demand would be limited at best, as lending rates are fairly low and further reduction in interest rates by banks and other lenders might be minimal (possibly 10 to 20bps). Credit offtake by the corporate sector has been low over the last few years on account of subdued investment demand and stressed bank & corporate balance sheets. The RBI and government have been taking various measures to deal with the balance sheet stress, latest being the Insolvency Code, but it appears that this issue will require more time to be resolved. The RBI has also decided to review the Marginal Cost of Funds based Lending Rate (or MCLR) framework to ensure better transmission of interest rates by Banks to existing borrowers. If resolved effectively, this would reduce stress on corporate balance sheets by lowering interest cost.
Equity markets were down approx. 0.3%, whereas yield of the 10-year benchmark G-sec was stable post the policy announcement. Yields on longer dated securities have remained range-bound over the last couple of months, with the 10-year G-Sec moving in the range of 6.40% to 6.50%. CYTD, rupee has appreciated approx. 6% against the U.S. dollar on the back of strong FPI inflows in the domestic equity and debt markets, combined to the tune of approx. $26 billion. Going ahead interest rates on short term debt instruments might trend lower by 15 to 20 bps in line with the lower repo rate whereas yields on medium and long-term debt would take cues incoming data on inflation and growth over the next few months to gauge if further rate cuts by the RBI are possible.