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RBI tones down; but still on hold - Outside View by Arvind Chari

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RBI tones down; but still on hold
Jun 8, 2017

The Monetary Policy Committee (MPC) of the RBI resolved to leave the key interest rate (Repo Rate) unchanged at 6.25%.

But the decision was not unanimous.

The MPC voted 5-1 to remain on hold. This is the first time since the MPC was first formed in October 2016 that a rate decision was not secured with a 6-0 vote.

Dr. Dholakia, one of the 3 external members in the committee, voted against the decision and based on his earlier comments and on the overall context of today's policy, we believe he would have favored a rate cut.

There are enough fundamental reasons that have built up in the last two months to warrant more accommodation from the RBI.

First, global commodity prices have completely given up on the 'Trump-Reflation' trade. Most commodities and now including global food prices have dropped quite significantly in dollar terms. Domestic Indian price pressures have also weakened considerably. The seasonal increase in fruits and vegetable prices in the summer did not happen this year leading to a marked fall in food price inflation. Core prices are increasing at a slower pace than anticipated as domestic demand pressures remain muted. The nominal and Real INR appreciation since the start of the year is providing further buffer against domestic inflation.

We believe the next 2-3 months CPI reading will be below 3%, also the full year trajectory should be closer to the RBIs target of 4% headline CPI inflation. The Inflation trajectory is running atleast 70-100 bps below RBI's forecasts. To that, the expectation of a normal monsoon should help cap inflationary expectations. The government also seems to have done its part by pegging the GST (Goods And Services Tax) in such a manner so as to have almost no impact on headline CPI inflation.

The RBI did acknowledge these and has thus revised its inflation projections sharply downwards.

'The April reading has imparted considerable uncertainty to the evolving inflation trajectory, especially for the near months. If the configurations evident in April are sustained, then absent policy interventions, headline inflation is projected in the range of 2.0-3.5 per cent in the first half of the year and 3.5-4.5 per cent in the second half'.

Monsoon and GST uncertainties apart from global commodity prices were the reasons which made RBI move its monetary policy stance from accommodative to neutral in February. Those worries have significantly abated but the RBI still seems to have chosen to be careful and await more data.

Table 1: RBI MPC finding its feet?
MPC Meeting Expectation Decision Voting Stance
October 2016 Hold rates unchanged Repo Rate cut by 25 bps to 6.25% 6-0 Growth Focussed; Dovish 4% CPI inflation target over medium term
December 2016 Repo Rate Cut by 25 to 50 bps Repo Rate Unchanged 6-0 Inflation worries Demonetisation fuzziness
February 2017 Repo Rate Cut by 25 bps Repo Rate Unchanged 6-0 Commitment to 4% target; Stance changed to Neutral from accommodative sighting global conditions
April 2017 Hold Rates Repo Rate Unchanged 6-0 Neutral Stance; Steps to remove excess liquidity. Hawkish tone
June 2017 Hold Rates Soft Stance Repo Rate Unchanged 5-1 Neutral stance maintained; Inflation forecasts lowered
(Source : RBI)

The above table should provide some insight on why the RBI is sounding cagey despite data supporting outright accommodation. It could be that given they turned cautious and neutral in February and April ( to be ahead of the cycle), it would be a pretty big climb down to cut rates then in June.

"The current state of the economy underscores the need to revive private investment, restore banking sector health and remove infrastructural bottlenecks. Monetary policy can play a more effective role only when these factors are in place. Premature action at this stage risks disruptive policy reversals later and the loss of credibility. Accordingly, the MPC decided to keep the policy rate unchanged with a neutral stance and remain watchful of incoming data"

To be honest, the RBI's monetary policy stance since December 2016 till now has helped them regain credibility which seemed to have had eroded post the October policy and during the demonetization related fiasco. Thus the stated worry on loss of credibility on another policy reversal.

We empathize with the RBI's current dilemma and we would rather the RBI err on the side of caution. Especially, near the end of a rate easing cycle.

We have seen historically that Indian inflation does not remain at the lower bound for too long and the latent demand does cause price rises in the economy. Also, in the current monetary policy framework of 4% inflation plus 1-2% Real Rates, for the RBI to cut the Repo rate to below 6% requires 'consistent conviction'.

A 25 bps cut matters a lot to bond traders but for the RBI and the broader economy it need not move the needle by much. The RBI needs to be convinced about the durability of the dis-inflation and confident enough to ease rates by atleast 50 bps to help support the economy.

We thus can expect rate cut going forward (maybe in August itself) but it won't be large.

The bond markets though have been correct in their anticipation of some easing and it is reflected in the falling bond yields since the introduction of the new 10 year benchmark bond in May. Although, not many expected a cut, but most expected a change in tone and were positioned as such and they seem to have been rewarded for it. The moment Dr. Viral Acharya (RBI Dy. Governor) mentioned "...and if the data so warrants, act for a broader accommodation through the interest rate policy" in the press conference, the bond market rallied a further 5-10 bps across the curve.

Since the start of the year, we have maintained the view that the best of the bond market gains are behind us and investors should lower return expectations from bond funds. The current move down in bond yields and the potential of some more on further rate cuts may lead to improved bond return performance than anticipated but investors may still consider it only as a tactical and a short term outcome.

Arvind Chari is Head Fixed Income & Alternatives at Quantum Advisors Pvt Ltd and advises two India dedicated off-shore India fixed income funds. Arvind was previously the fund manager for the Quantum Liquid Fund and the Quantum Equity Fund of Funds at Quantum Asset Management Company Pvt Ltd.

Disclaimer:

The views expressed in the Article are the personal views of the author, Arvind Chari and not views of Quantum Advisors Private Limited (QAS). QAS may or may not have the same view and does not endorse this view. The views expressed here in this article are for general information and reading purpose only and do not constitute any guidelines and recommendations on any course of action to be followed by the reader. The views are not meant to serve as a professional guide / investment advice / intended to be an offer or solicitation for the purchase or sale of any financial product or instrument. Information sourced from third parties cannot be guaranteed or was not independently verified. Whilst no action has been solicited based upon the information provided herein, due care has been taken to ensure that the facts are accurate and views given are fair and reasonable as on date.

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