Prospects of further rate cuts uncertain
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As widely expected, the monetary policy committee (MPC) held the policy repo rate steady, deeming the environment too risky to warrant any further easing at this point, and again emphasizing the need for “bringing headline inflation closer to 4% on a durable basis”.
Any further move on rates, in either direction, will depend on evolving economic conditions. That leads us to the macroeconomic projections. On inflation, the MPC, while acknowledging that the March 2017 inflation forecast of 5% will be undershot (we think the inflation print might come in just under 4%), is clearly of the view that price pressures will take the trajectory up, with a forecast average of 4.75% for the current fiscal year.
Although our own forecast is lower, it has to be acknowledged that there are significant latent upside risks, stemming from persisting higher metals prices, the imminent switch to the goods and services tax (GST), uncertain rains and diffusion of 7th Pay Commission salary and pension recommendations to the states, among others.
Of greater concern to a central bank, the MPC notes that household inflation expectations, both three-month and one-year ahead, which had dipped in the December survey, have picked up in the current round, “across product groups”.
RBI’s Industrial Outlook Survey (IOS) indicates a return of corporate pricing power.
On economic activity, GVA (gross value added) growth is projected to revive to 7.4% in fiscal 2018 from 6.7% in the just ended financial year. Capacity utilization has dropped marginally to 72.7% for the December quarter from 73.1% in the three months ended September, indicating a persisting output gap which can allow quicker growth without materially pushing output costs (although this is in partial contradiction with the IOS mentioned earlier). Be that as it may, the growth-inflation trade-off does not suggest the need to ease in any great hurry.
The focus of this policy review, however, was a guidance on strategy to manage liquidity in the near term and over the year. Ceasing the use of cash management bills by early March had led to a marked divergence of money market rates from the policy rate which is counter to monetary policy operating procedure.
Markets (banks and eligible participants for RBI’s liquidity adjustment facility window) have generally been averse to offer excess liquidity in longer term repos, preferring to park their funds in shorter maturity instruments. Mutual funds, which have absorbed significant funds, do not have significant quantities of short-term instruments (either bank certificates of deposit or commercial paper), thereby parking funds in collateralised borrowing and lending obligation (CBLO), opening opportunities for arbitrage and circular flows.
It appears that durable liquidity will not reduce rapidly as earlier expected. Yes, bank deposits will progressively fall. Remonetization (i.e. cash withdrawals) has remained quite high in the three months since January since RBI began to progressively relax currency restrictions. But an expected balance of payments surplus via large capital inflows will add longer maturity funds, thereby keeping a Rs2 -3 trillion surplus over much of the current fiscal year.
The operative action of monetary policy was to further narrow the repo-reverse repo corridor from 50 basis points on either side of the repo rate to 25 basis points. The corridor width is another monetary policy tool meant to more closely align the call rate with the policy repo rate, anchoring the overnight rate at the desired target level. This tightening will help close the gap referred to above.
There was also a lucid communication and guidance on the use of various liquidity management instruments, mapping instruments and channels to the nature of the liquidity mismatch and market participants.
Only the judicious and selective use of open market operations (OMOs), intimated well in advance, will help moderate undue volatility in yields. These instruments will eventually be augmented by a Standing Deposit Facility (SDF), designed to be a spillover vehicle in times of high excess liquidity leading to a shortage of collateral. The design of the SDF, including the offered rate of interest, will be awaited.
In addition, RBI, probably to partially address the problem (as noted above) of the reluctance to offer excess liquidity in longer term reverse repos has liberalized the collateral requirement used for drawing liquidity. By providing operational flexibility, this is likely to induce further transactions in medium tenor (28 days and longer) term repos, which will help build out benchmark yield curves, critical for developing the corporate bond market.
Revival of credit growth remains the key problem. RBI’s second major endeavour, along with rebalancing liquidity conditions, is to accelerate the resolution of stressed assets. Initial statements suggest a more specific, customized, sector-based approach to the resolution mechanisms. This will help in alleviating the leverage and cash flow problems at some of the stressed companies, but broader measures are required to address excess capacities in infrastructure segments.
Saugata Bhattacharya is chief economist at Axis Bank.