The most significant announcement for bond markets did not form part of the Reserve Bank of India’s (RBI) review of monetary policy. Instead, it was contained in a separate statement announcing that RBI will buy back Rs12,000 crore worth of bonds falling in the 5-10 year maturity bucket.
The move signalled that RBI aims to address persistently high deficit liquidity conditions. The move was in line with the central bank’s intention—outlined in the policy statement—to bring down system deficit to within 1% of net demand and time liabilities of around Rs50,000 crore. Considering that the current level of deficit is around Rs80,000 crore and that it may rise to beyond Rs1trillion in mid-December on the back of advance tax outflows, RBI will have its task cut out in achieving its objective. To be sure, increased government spending in the interim and any intervention by RBI in the forex market may also alleviate the liquidity situation. RBI’s intention on liquidity and decisive action to implement the same will provide comfort to the broader financial market.
Coming to the policy itself, RBI signalled its discomfort with the persistently high headline inflation by hiking liquidity adjustment facility rates by 25 basis points each. One basis point is one-hundredth of a percentage point. RBI correctly flagged off both supply side and demand side upside risks to inflation in the coming months. In RBI’s view, high food prices, should they prevail for long, carry the risk of transmitting itself to higher core inflation via higher wages. On the other hand, there can be legitimate doubts about whether monetary policy can contain headline inflation when fiscal policy continues to be expansionary. I have been in the camp that RBI should stop targeting headline inflation and start referring to core inflation. However, ground realities may not permit such a pivot and it is commendable that RBI continues to accept low and stable headline inflation as its dharma.
In the near-term, like most stakeholders, RBI expects food prices to cool off thanks to a bumper kharif harvest. The consequent moderation in headline inflation may allow RBI to hold off from further rate hike in the December mid-term review and, perhaps, in the January quarterly review. The central bank indicated as much in the policy statement with a proviso that it will respond to any unforeseen events. Beyond the next two policy reviews, there is a good likelihood that RBI may need to up policy rates.
I see some risk that headline inflation may not fall to 5.5% by March 2011. Over the medium-term, I believe that policy rates may need to rise much more if RBI wants to contain headline inflation in the 5-5.5% zone. However, that is a battle for another day.
For now, RBI may have pulled off the difficult task of tempering inflation expectations, while modulating liquidity conditions. The only misgiving with Tuesday’s announcements is that buying long-duration bonds to infuse short-term liquidity appears inconsistent. One only hopes that if and when the time comes to suck out liquidity from the system, RBI will not hesitate to unload some of the duration bonds that it will end up buying in the coming weeks.
A Prasanna is head research at ICICI Securities Primary Dealership Ltd.
These are the author’s personal views.
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