RBI monetary policy sends positive signals for bond markets
A dovish RBI monetary policy, on top of a favourable government borrowing programme and MTM relief for banks, should trigger the bulls in the bond market in the coming months
Last December, the Monetary Policy Committee (MPC) estimated the next quarter’s (January to March 2018) inflation to be 5.1%. However, their assessment now for that same quarter is 4.7%.
Of course, data for two months is now known, and only March data is awaited, which will not be available for another week. Thus it is clear that four months ago there was an overestimation of inflation.
Why is there almost a systematic overestimation of inflation by the MPC? Are the forecasts doomed to always be conservative? Is the inflation model flawed? The government’s chief economic adviser had rather caustically observed last year that the RBI had overestimated inflation by 180 basis points for the past 14 quarters.
Of course, forecasting inflation in India is never easy, as it is dominated by food prices, including those of fruits and vegetables, all of which fluctuate quite wildly. When confronted with volatile price movement, being conservative is the dharma of monetary policy. Hence the usually hawkish stance.
But this time we have a pleasantly dovish signal. The MPC regime of flexible inflation targeting (FIT) began almost 18 months ago.
During this period, the actual inflation numbers have never crossed outside the band of the flexible target of 2 to 6%. Indeed, India’s inflation has stayed in that band for almost four years now, and the memory of double-digit inflation prior to September 2013 is fading. Many analysts believe that India has moved to a structurally lower inflation band, a view articulated by one of the members of MPC.
Yet the quarterly household inflation expectations surveys conducted by RBI continue to hold higher (not double-digit) expectations. Slaying this expectations monster is the real task of flexible inflation targeting and the MPC.
The MPC has also revised downward its estimate of inflation for next year, indicating no rate hikes for the full year. This may seem odd in light of higher oil prices (compared to last year), and the fact that the US Federal Reserve is almost surely going to hike policy rates four times during 2018.
This means that the interest arbitrage between dollar and rupee rates will narrow, but that won’t deter the inflow into government and corporate bonds markets. Indeed the foreign investment in that portfolio is filled to the brim, and the quota ceiling may be raised further.
Apart from this impending increased dollar inflow into the bond market, there was much to cheer. The government wisely announced a reduction in its borrowing programme for the first half of this fiscal. This caused a rally in bonds.
Further the RBI gave relief to banks, by allowing them to spread out their marked-to-market losses on their bond holdings, over the next four quarters. This leaves some extra funds with banks, who can then buy more bonds, adding to the rally. If the trend of higher monthly collections in GST continues and we have a smooth implementation of the e-way bill, the fiscal signal will be positive for bonds.
Overall, expect some bullish trends in the bond market in the coming months. The postponement of implementation the new accounting standards is also a positive for banks, which was promptly validated by the rally in banking stocks.
Even though the MPC is sounding dovish, it is not as if it has ignored the upside risks to inflation. Crude oil prices may move up, there may be fiscal slippage, especially with the state governments, the impact of minimum support prices for crops may move food prices up, the impact of higher house rent allowance for government employees recommended by the seventh pay commission may feed into inflation, and of course the possibility of monsoon failure, are all to be watched.
Added to all this is the uncertainty about how the trade war will unfold.
The outlook on growth is upbeat, with GDP growth moving from 6.6% last year to 7.2% next year.
The continuing strength of consumption spending, manifest also in surging imports, gives confidence to this forecast. The world economy including emerging markets is in a synchronized strong upward momentum.
Global trade is growing robustly and this should help India’s exports. Of course the current US-China trade spat is a spanner in the works, but hopefully wiser counsel will prevail, and markets and economies can go back to cruising upwards.
Ajit Ranade is economist and senior fellow at Takshashila Institution.
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