Monetary Policy Review - October 2017
As widely expected, the RBI kept policy rates unchanged and maintained its neutral monetary policy stance at its fourth bi-monthly policy meeting for 2017-18. Consequently, the repo rate remains at 6%, the reverse repo at 5.75% and the marginal standing facility rate and Bank rate at 6.25%. The RBI reiterated its medium-term target for consumer price index (CPI) inflation of 4% within a band of +/- 2% while supporting growth. RBI reduced the SLR by 50bps from 20% to 19.50% and the ceiling on SLR securities under Held to Maturity (or HTM) from 20.25% to 19.50% of Net Demand and Time Liabilities (or NDTL) in a phased manner. These measures are in line with its long-term objectives.
The MPC appears to be concerned with the rise in inflation by 2% over the last couple of months. Alongside, an escalation in global geo political uncertainty and heightened volatility in financial markets due to the US fed's plans of balance sheet unwinding and the risk of normalization by the European Central Bank could have contrasting effects on inflation. The committee did acknowledge the likelihood of the output gap (or the difference between potential and actual GDP growth) widening but required additional data to ascertain whether the gap is temporary or sustained.
Although, headline inflation has been broadly in line with the projections made by RBI in August, the rise in core inflation (headline inflation excluding food and fuel) has been higher than expected. The trend in inflation for the rest of FY18 would be based on several factors including direction of food prices based on the sowing pattern, price revisions for some goods based on the GST implementation, the broad-based increase in CPI inflation excluding fuel and food and rising international crude oil prices. Based on these factors, the inflation projection for the second half of FY18 has been increased to 4.2% to 4.6% from 4% to 4.5% indicated in the previous policy. Additionally, there are upside risks to this baseline inflation trend including implementation of farm loan waivers by states resulting in fiscal slippages, states' implementation of the salary and allowances award for government employees hasn't been considered in the baseline projection which could push inflation up by another 100bps over the next 18 to 24 months with potential second round effects. However, adequate food stocks and effective supply management by the government may keep food inflation more benign than assumed in the projections.
RBI also reduced its growth projections for 2017-18 made in August, from 7.3% to 6.7% sighting the loss of momentum in Q1 of 2017-18, lower than expected first estimates of kharif foodgrain production, short term adverse impact of GST implementation causing a further delay in revival of investment activity which is already hampered by stressed balance sheets of banks and corporates. On the positive side, firms expect a significant improvement in business sentiment in Q3 on account of better prospects of production, order books, capacity utilisation, exports and profit margins.
Impact on overall economy
RBI has been concerned about the inadequate transmission of lower policy rates by banks to borrowers, particularly on existing loans. Accordingly, the central bank had set up a study group to review the internal benchmarks such as base rate / MCLR used by banks to determine lending rates. The study group believes that these benchmarks are calculated on an arbitrary basis and are not in sync with global practice. The RBI will take a final view on the issue after receiving public feedback & comments on the report. The MPC was of the view that various structural reforms introduced by the government in the recent period are likely to boost growth over the medium to long term. They reiterated the need to revive investment activity in the economy, resolve the issue of stressed bank balance sheets and recapitlaise public sector banks to support growth. In our view clearly these factors would play a critical role in determining the future course of the economy.
Equity markets were up approx. 0.6%, whereas yield of the 10-year benchmark G-sec rose by 7 bps post the policy announcement. Yields on longer dated securities have remained range bound over the last couple of months, with 10-year G-Sec moving in the range of 6.40%-6.60%. However, yields inched up further in last one month amid higher than expected August CPI inflation, and the US Fed's communication signalling one more possible rate hike in 2017 and initiation of balance sheet normalisation from October 2017. CYTD, rupee has appreciated approx. 4% 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. $25 billion. However, in last one-month rupee has depreciated approx. 2% against the dollar on account of FPI outflows. Going ahead interest rates on short term debt instruments might remain range bound and close to LAF (Liquidity Adjustment Facility) rates, given low probability of repo rate cut in the next RBI policy meeting. Yields on medium and long-term debt would take cues from incoming data on inflation and growth over the next few months to gauge RBI's policy action, if any.