Monetary Policy review - October 2016
The Reserve Bank of India cut its benchmark repo rate by 25 basis points to 6.25%. This is the first cut in the repo rate since April this year. The other key rates such as the cash reserve ratio were left unchanged.
Today's interest rate decision is the first under the new RBI governor Dr. Urjit Patel and the first decision by the newly constituted Monetary Policy Committee. All six members of the MPC voted in favour of the rate cut. The committee believes that the rate cut is consistent with the accommodative stance of monetary policy and also consistent with the objectives of achieving an inflation rate of 5% by the end of this year and 4% in the medium term.
The accompanying Monetary Policy Report lays down some justification for the rate cut. While the RBI expects inflation to remain close to 5% this year, it expects some moderation to 4.5% by the end of FY18. This projection takes into account some of the effects of the Pay Commission award and an expected increase in minimum wages. However the second round effects of the Pay Commission have not been considered.
The RBI also pointed to GST as a source of some inflation risk going forward. As the tax rates under GST are not known, the Reserve Bank has used the Government's report as the base case – i.e. a revenue neutral rate of about 15-15.5% having minimal impact on inflation. This is consistent with a base GST rate of 18% with a preferential rate of 12%. In case the tax rates are higher, it is possible that there could be some upward pressure on inflation. In this the RBI has also surveyed other countries which implemented a nation-wide VAT with a view to understanding the impact on inflation. The broad experience across the world appears to be a higher push in the inflation rate, with inflation remaining elevated for about a year after introduction of a GST-like tax.
The market reaction to the policy has been muted with the 10-year benchmark relatively unchanged from yesterday's level. The bond market had rallied sharply over the past quarter in anticipation of the rate cut – for example the benchmark 10y yield dropped 60 basis points from 7.5% to 6.9% since late June.
Short to medium term G-Secs have seen yields dropping in response to the policy rate cut. The outperformance of shorter bonds over long bonds is a characteristic of late stages of rate cut cycles. The shorter segments are more sensitive to rate cuts and liquidity infusion in comparison to the long end which is more sensitive to emerging macro developments. Going forward we expect the markets to watch CPI prints to see if inflation follows the expected downward trajectory over the coming several months.