RBI Watch: Waiting for more concrete signals

As widely expected, the Reserve Bank of India (RBI) maintained status quo on the policy rate. As the key reasons for keeping policy rate unchanged, the RBI pointed to sharper-than-anticipated increase in food inflation and the uncertainty related to crude oil prices.

However, on balance, the RBI retained its inflation projections (i.e. of a central trajectory towards 5% by March 2017) and suggested that room for rate cuts could still arise in the future - if progress in the monsoon continues to be steady and food prices ease as expected.

We expect food inflation to start tempering from September onwards. Thus, in our view, room for one more policy rate cut could transpire in the last quarter of 2016. Post that, we expect a long pause, as onus shifts to government reforms and structural changes to move towards the 4% inflation goalpost.  

Monetary and Liquidity measures by the RBI

·        The policy repo rate under the liquidity adjustment facility (LAF) unchanged at 6.5%. 
·        The cash reserve ratio (CRR) of scheduled banks unchanged at 4.0% of net demand and time liabilities (NDTL) 
·        Continue to provide liquidity as required but progressively lower the average ex ante liquidity deficit in the system from 1% of NDTL to a position closer to neutrality.

RBI’s review of Growth Conditions

“Successive downgrades of global growth projections by multilateral agencies and the continuing sluggishness in world trade points to further slackening of external demand going forward. Accordingly, the GVA growth projection for 2016-17 is retained at 7.6 per cent, with risks facing the economy at this juncture evenly balanced around it”

·        External Sector: On the global front, RBI pointed to the re-emergence of concerns in the European banking sector and increased uncertainty on account of Brexit. For Japan, the RBI stressed on the downside risks on account of stronger yen and contracting industrial output. With regards to the US, the RBI expressed confidence that slowdown in GDP growth (on account of declining inventory investment) has been offset by strong payroll numbers. For emerging markets, the RBI said that although outlook is fragile, the recessionary conditions are gradually diminishing. 
·        Domestic Growth: The progress in monsoon engendered greater confidence and RBI seems to be optimistic about the near term outlook for agricultural output. For the industrial sector, while RBI pointed to pick up in output for the month of May, it still remained concerned about the prolonged sluggishness in capital goods sector and the weak investment demand in the economy. On the services sector, RBI said that while the trend for auto sales and freight traffic is improving, there are still mixed signals regarding the outlook ahead. 

RBI’s review of Inflation Dynamics:

“Risks to the inflation target of 5 per cent for March 2017 continue to be on the upside. Furthermore, while the direct statistical effect of house rent allowances under the 7th CPC’s award may be looked through, its impact on inflation expectations will have to be carefully monitored so as to pre-empt a generalization of inflation pressures. In terms of immediate outcomes, much will depend on the benign effects of the monsoon on food prices.”

·        As the allowances decision (under the 7th Pay Commission awards) has been deferred, the direct impact of the rise in HRA component on inflation is likely to be muted and spread-out over FY17 and FY18. Moreover, with the rise in reservoir levels and a steady monsoon trajectory, food inflation is likely to ease in 2H-FY17. However, the uncertainty still prevails with respect to inflation expectations of the households and the trajectory of global crude prices. As a result, RBI maintained its bias of marginal upside risk to 5% inflation target.

RBI’s review of Liquidity Conditions: “Liquidity conditions eased significantly during June and July on the back of increased spending by the Government which more than offset the reduction in market liquidity because of higher-than-usual currency demand….Reserve Bank intends to continue with this strategy, with the intention of closing the underlying liquidity deficit over time so that the system moves to a position of structural balance.”

·        In our view, the uptick in government spending on account of pay commission is likely to fade as arrears are cleared in August and incremental expenditure thereafter shall remain somewhat muted (around Rs. 6000 crores per month). The currency leakage is likely to pick up on account of seasonal factors. Lastly, the growth rate of government expenditure is likely to moderate in H2-FY17 after front-loading of expenditure in H1-FY17. Thus, October onwards the liquidity situation is expected to worsen. Against such a backdrop, it is clear that RBI’s stance shall be to maintain underlying structural balance to a position close to neutrality. Therefore, as a pre-emptive step and with a view of front-loading the provision of liquidity, the RBI announced OMO purchases today.

Policy Rate Outlook: Our base case scenario is that food prices would ease with normal monsoon and decline in global food prices. However, given the sticky services sector inflation and a likely boost in rural consumption, the fall in headline inflation is unlikely to be drastic enough to encourage more than one policy rate cut in FY17.