Home >opinion >RBI delivers as expected

The last monetary policy statement of Raghuram Rajan’s term as Reserve Bank of India (RBI) governor contained no surprises.

Rajan’s policy stance and forward guidance were absolutely in line with our expectations—retaining the upward bias to March 2017 inflation estimates, keeping growth forecasts unchanged and reiterating that RBI’s monetary policy stance remains accommodative. The rationale for status quo was obvious—the rise in food prices since April that has pushed up RBI’s projected inflation trajectory. Given that the correlation between monsoon rainfall and inflation is not very strong, we had expected RBI to remain watchful.

Furthermore, RBI expectedly reiterated its intention to smoothen the supply of durable liquidity by progressively lowering the average liquidity deficit in the system to a position closer to neutrality. This is likely to be achieved over the course of a year or two through adequate open market operations (OMOs).

To add to that, we have the upcoming redemptions of foreign currency non-resident deposits and consequent liquidity mismatches during the September-November period. As noted in the policy statement, RBI has been front-loading liquidity provisions for management of the redemptions through OMO purchases and spot interventions/deliveries of forward purchases. This may prompt markets to scale back on their expectations of OMO purchases in the second half of the fiscal year as RBI has already conducted OMO purchases worth 80,500 crore till date.

However, we must highlight that despite aggressive OMO purchases in the first quarter of the fiscal year, payback in currency in circulation and healthy government spending, the average liquidity deficit till date has been seasonally at similar levels (~ 53,000 crore) as last year.

We thus continue to expect ~ 1.6 trillion of OMO purchases in the remainder of the year, assuming limited room for liquidity infusion through the foreign exchange route as the balance of payments surplus is likely to hover around $5-10 billion.

Either way, easy liquidity conditions are likely to improve the transmission mechanism and translate eventually into lower lending rates. With RBI continuously working towards refining the tools for transmission (such as the recent announcement of tweaking the marginal cost of funds-based lending rate, or MCLR, norms), we expect a more transparent and smoother pass-through.

Meanwhile, from a rates perspective we continue to retain our call for a 25 basis points rate cut in calendar year 2016. We expect RBI will realize its 5% inflation target by March 2017 amid favourable base effects and fading food price pressures.

Strong monsoon rainfall has boosted sowing of most kharif crops, especially pulses, whose acreage has surged by 35% year-on-year this year. However, looking beyond the current fiscal year, we remain cautious on the scope for further accommodation.

Regardless of the ideology of the soon-to-be-announced monetary policy committee, the fact that the inflation target of 4%+/-2% has been adopted until March 2021, we see limited room for additional easing in the new regime. We do not expect inflation to sustain below 5% as the disinflationary impulses have largely played out and supply-side bottlenecks will now keep the downward rigidities intact as the output gap narrows. Further, capping the downside to the headline inflation has been the persistently high rural inflation compared to urban retail inflation.

Also, with the wholesale price index inflation trajectory having bottomed out, we expect the pass-through of higher prices from tradables to non-tradables to further keep core inflation sticky. Lastly, the next fiscal year will also face the one-off inflationary impact arising from the increase in the Seventh Pay Commission-related housing rent allowances and the likely implementation of the goods and services tax.

Upasna Bhardwaj is a senior economist at Kotak Mahindra Bank.

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