Everyone had been expecting the Reserve Bank of India (RBI) to cut its policy rate by a quarter of a percentage point. The Monetary Policy Committee (MPC) of the Indian central bank didn’t disappoint.
The six-member MPC voted 4-2 in favour of the cut, which has brought down the policy rate to 6%, a level last seen in September 2010. Governor Urjit Patel, deputy governor Viral Achaya, Chetan Ghate and Pami Dua were in favour of the monetary policy decision; Ravindra Dholakia’s pitch for a half a percentage rate reduction was a perfect foil to Michael Patra’s argument for status quo. The bond yield remained flat after the rate cut announcement as the market had already priced in the cut. The lack of a surprise element in the policy action and the stance (which remains neutral) demonstrate the maturity that the MPC has been acquiring since it first met in October 2016.
As the monetary policy stance continues to be neutral, the MPC is not committing to a future course of action. However, a close reading of the policy statement makes it clear that the chances of the next rate cut are slim at the moment. It can happen only if there is a positive surprise on the inflation front, as it had happened in June (and led to this rate cut).
The second bimonthly monetary statement in June had projected quarterly average headline inflation in the range of 2-3.5% in the first half of fiscal 2018, and 3.5-4.5% in the second half. Now it expects inflation to be about 4% by the year end. As long as inflation follows this track, there will not be any more rate cuts during this fiscal year.
However, many analysts believe that the MPC’s estimate is conservative and inflation could be slightly lower than 4% by March 2018. If indeed their assessment is correct, we could see another rate cut before the year ends. The MPC has stuck to its objective of achieving the medium-term target for retail inflation of 4% within a band of +/- 2%, while supporting growth.
In June, retail inflation dropped to a record low on account of a favourable base effects which the MPC expects to wear off and even reverse from August. Prices of food and beverages, which went into deflationary mode in May, dropped further in June.
Fuel inflation too declined for the second month in succession in June. Finally, excluding food and fuel, retail inflation moderated for the third month in succession in June, falling to 4%.
The MPC feels that as the base effects wear off, the implementation of house rent allowances under the 7th central pay commission, certain price revisions withheld ahead of the GST, and the trend in food inflation—will have an impact on retail inflation in coming months. It sees uncertainty in the shape of fiscal slippages and lower public spending by different states, following the farm loan waivers as well as likely salary and allowance revisions by the states. The neutralizing factors could be a normal monsoon and stable international commodity prices.
Even though the policy statement has expressed concerns on a weak industrial performance and the broad-based loss of speed in manufacturing, the RBI has kept its economic growth estimate for 2018 unchanged at 7.3%. It also says that the joint efforts by the government and the RBI to resolve large stressed corporate borrowers and to recapitalize public sector banks, should help restart credit flows to the productive sectors as demand revives.
While the next rate cut will depend on the trajectory of retail inflation and companies will start lifting loans when they get back their appetite for investments, the bigger challenge before the RBI is to manage the deluge of liquidity in the system.
It has sucked out surplus liquidity of Rs1 trillion through treasury bills under the market stabilization scheme (MSS) and Rs1.3 trillion through cash management bills so far this financial year. It also flushed out Rs10,000 crore each in June and July by selling bonds through the so-called open market operations (OMOs), and another tranche of Rs10,000 worth of bond buying will happen in August.
In the face of strong foreign money flow into India, RBI has been continuously intervening in the foreign exchange market—both in the spot as well as forward segments—and for every dollar it buys, an equivalent amount of rupees is flowing into the system. The government will probably have to raise the MSS limit (capped at Rs1 trillion in the current fiscal year) and RBI will have to look for new instruments to absorb liquidity. A low remunerated standing deposit facility could be one such tool which the expert committee to revise and strengthen the monetary policy framework suggested in January 2014. RBI has been discussing this with the government but I understand the government is not too excited about this.
In the face of strong foreign money flow into India, the RBI has been continuously intervening in the foreign exchange market —both in the spot as well as forward segments. It has a tough choice: if it does not intervene, the local currency will get stronger against the greenback and for every dollar it buys, an equivalent amount of rupee is flowing into the system. So it needs to sterilize that money from the system.
The government will probably have to raise the MSS limit (capped at Rs1 trillion in the current fiscal year) and the RBI will have to look for new instruments to absorb liquidity.
A low remunerated standing deposit facility could be one such tool that the expert committee to revise and strengthen the monetary policy framework had suggested in January 2014. RBI has been discussing this with the government, but I understand the government is not too excited about this.