RBI policy: optimistic on growth, pessimistic on inflation

RBI is unlikely to tolerate a situation where liquidity is so abundant that money market rates are lower than its policy rate


The fact that the cash reserve ratio (CRR) was left unchanged was cheered by both the bond market and banks. Graphic: Subrata Jana/Mint
The fact that the cash reserve ratio (CRR) was left unchanged was cheered by both the bond market and banks. Graphic: Subrata Jana/Mint

Here’s what the Reserve Bank of India (RBI) said in its April 2017 Monetary Policy Report, released on Thursday: “Underneath current benign inflation conditions, there are broad-based inflation pressures, which make the inflation outlook for 2017-18 challenging. Growth in real gross value added (GVA) is expected to accelerate in 2017-18, underpinned by strong consumption demand even as investment activity remains muted and external demand uncertain.”

That statement is very significant, as it implies that the central bank remains wary of upside risks to inflation on the back of strong prospects of economic growth in the current fiscal year—it sees the output gap gradually closing, which could push inflation higher.

As Gaurav Kapur, chief economist at IndusInd Bank, said, “While RBI is optimistic on growth, it is pessimistic on inflation.” With higher growth and inflation, there’s no more space for rate cuts.

Also Read: RBI targets excess liquidity in continuing focus on inflation

Further evidence of this line of thinking comes from RBI’s baseline projections of growth in GVA, which it expects to improve from 6.7% in FY17 to 7.4% in the current fiscal year and further to 8.1% in FY19. Clearly, the central bank is expecting growth to pick up substantially.

On the other hand, the monetary policy statement has a long laundry list of upside risks to its inflation forecasts for 2017-18, which includes a possible El Niño, the impact of loan waivers in agriculture, the effects of the goods and services tax and various other factors. The Monetary Policy Report says, “Headline inflation is projected to increase during 2017-18, calling for close vigilance and readiness for an appropriate monetary policy response, if warranted.” RBI’s baseline projection is of consumer price inflation going up from 3.6% in the March 2017 quarter to 4.9% in the March 2018 quarter. Although inflation is projected to be lower in the March 2019 quarter (see chart), with GVA growth accelerating it’s going to be a tall order.

Given RBI’s fears of inflation and its medium-term objective of moving towards a 4% inflation rate, there is no way in which it can tolerate a situation where liquidity is so abundant that money market rates are lower than its policy rate. Hence the central bank raising the reverse repo rate by 25 basis points to 6%, to align it closer with its objective of keeping overnight money market interest rates near the repo rate. Hence also its focus on sucking out excess liquidity using all the tools at its command, including the market stabilisation scheme, longer tenor variable reverse repos and open market operations.

What is the impact on markets?

The fact that the cash reserve ratio (CRR) was left unchanged was cheered by both the bond market and banks. India’s benchmark 10-year bond yield rose five basis points to 6.75% post-policy. In February, RBI unexpectedly changed its policy stance to “neutral” from “accommodative” stating inflationary concerns, after which a sharp upmove was seen in bond yields.

As Indranil Pan, chief economist at IDFC Bank, writes, “Bond yields had dipped in the run-up to the policy, anticipating a new liquidity management tool that could have the overnight rate dropping lower. However with no such move coming through, the 10-year benchmark yield has moved back to 6.77%. With RBI now expected to be on a longish pause, I think the range for the 10-year yield could be in the region of 6.6-6.85% for the next four-six months.”

Also Read: Full text of RBI’s monetary policy statement

As far as banks are concerned, yes they will be able to earn additional interest of 0.25% from RBI by parking surplus funds with it, but since opting for this option will only have a marginally positive impact on their balance sheets, it is unlikely that many banks will choose this as a source of getting additional income. A larger positive for banking stocks would have come if more clarity could have been provided on the non-performing asset mess. The Bank Nifty closed marginally negative on Thursday, while the PSU Bank Nifty fell 1%.

One didn’t see the rupee reacting to the policy as it remained range-bound; expectations are that movement in the currency will be driven more by fundamental factors and foreign fund inflows.

In a first, RBI has permitted banks, mutual funds and insurance companies to invest in real estate investment trusts. But it has to be seen how this investment option evolves especially for banks because they are already reeling under bad loan problems and would not want to burn their fingers again by lending to the debt-ridden realty sector. Thus, the sharp surge seen in DLF Ltd’s stock on Thursday can at best be read as a knee-jerk reaction.

For the equity markets, what is perhaps more significant is RBI’s optimism about growth, which should translate into higher corporate earnings.

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