Monetary Policy Review - Feb 2017

Source: Morningstar

RBI in its sixth bi-monthly policy statement, kept the policy repo rate under the liquidity adjustment facility (LAF) unchanged at 6.25%. Accordingly, the reverse repo rate under the LAF remains unchanged at 5.75%, and the marginal standing facility (MSF) rate and the bank rate at 6.75%. Importantly, RBI changed its monetary policy stance from accommodative to neutral. Fixed income markets were taken by surprise with this move, as indicated by the jump in yields (10yr benchmark G-Sec yield moved up by more than 30 bps from 6.40% to 6.74%). The change in stance appears to indicate that further rate cuts in the near term (over the next 3 to 6 months) are quite unlikely given the RBI's outlook for inflation over FY17-18, with RBI projecting headline inflation (CPI) to rise to a level of 4.5 to 5 percent in Q3 and Q4. RBI also reiterated its commitment of bringing / maintaining inflation closer to 4% on a sustained and calibrated basis. On the positive side, RBI has clearly shifted its focus to the medium-term outlook on inflation rather than short term fluctuations.

 In terms of growth, although RBI has reduced its GVA forecast for FY 2017 from 7.1% (indicated in the previous policy) to 6.9% due to demonetization effects, they believe that growth should recover in the next fiscal to 7.4% on the back of revival in consumption demand (remonetisation), recovery in cash sensitive sectors (retail trade, transportation, hotels, etc.), lower lending rates due to surplus liquidity with Banks (demonetization effect) and the emphasis of the Union Budget 2017-18 on capital expenditure, affordable housing and the rural economy.

 Impact on overall economy

Transmission of lower policy rates to bank lending rates has improved in the recent past with the liquidity surge in the banking system, thanks to demonetization. Although corporate lending hasn't picked up and the RBI has highlighted key issues that need to be resolved, primarily by the government, including – high NPA levels, adequate recapitalisation of PSU banks and re-calibration on interest rates of small saving instruments based on set formula – for better transmission of lending rates particularly to corporates.  Shift of the monetary policy stance from accommodative to neutral also provides flexibility to RBI to act in either direction in case the growth recovery (or narrowing of output gap) is better than expected or inflation overshoots expectations. In the near term, lower interest rates should spur consumption demand particularly for durables including automobiles, white goods, etc. although demand for real estate remains uncertain given expectations of a further fall in prices and restrictions on cash transactions proposed in the Union Budget. Revival in capital expenditure is contingent on government spending as private sector investment continues to be subdued. Overall lower inflation rates tend to help the economy by spurring capital investments over the medium to long term and encouraging investors to shift from physical to financial assets.

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