After the sharp rise in inflation from 4.83% in March to 5.39% in April, the repo rate status quo was on the cards. The governor has admitted in the policy that the inflation was likely to be around the 5% mark with distinct upside risks. Additionally, the US Non-Farm Payrolls (NFP) data had come almost 70% lower in May compared to April. Although Indian IIP has slackened, the core sector growth and the GDP for the quarter were better than estimated. These are likely to rub-off on the IIP growth with a slight lag. Additionally, China was still growing too slow for global comfort and the best of monetary loosening efforts in Europe had failed to bring back growth. There is also an added uncertainty globally ahead of the US FOMC meet in mid-June and the critical BREXIT vote on June 23rd. It is in this background that the RBI review was presented on June 07th.
Highlights of the Monetary Policy announcement…
- The repo rate has been maintained at 6.5%
- The cash reserve ratio (CRR) has been maintained at 4% of net demand and time liabilities (NDTL)
- RBI will continue to focus on reducing the liquidity gap in the system with calibrated open market operations (OMOs)
- Consequently, the reverse repo rate remains at 6% and the Bank rate at 7%. Remember that in the previous policy, the RBI had reduced the spread between repo rate and bank rate from 100 bps to 50bps.
Focus shifts from rates to liquidity…
Like in the previous policy, the RBI has focused a lot more on liquidity rather than focusing purely on rates. In the last 3 months the average liquidity deficit has been brought down from Rs.200,000 crore to Rs.65,000 crore. In the last couple of months post the previous monetary policy, the RBI has infused liquidity to the tune of Rs.70,000 crore into the system through OMOs. Currently, the liquidity deficit in the system is at 1% of NDTL. In this policy the RBI has committed to bring this deficit to neutral. What does this mean for money markets?
Abundant liquidity in the system will ensure that the yields at the short of the market like call money and T-Bills will see a fall in yields. We had seen a sharp fall in yields post the previous policy, but they had again hardened in May. Thus what the RBI will not achieve through rate cuts, it has tried to achieve through greater liquidity infusion through OMOs.
Inflation and global uncertainty…
There are two factors that have spurred the RBI decision to maintain the status quo in this policy. Firstly, inflation has gone up sharply in the month of April to 5.39%. This is almost 56 bps higher than the inflation number seen in March. This rise in inflation was driven by food inflation, which tends to be sticky in nature due to its supply side constraints. There is also the risk of rising commodity prices globally. Oil has already crossed $50/bbl and the supply disruption in Venezuela, Nigeria, Canada and the US means that supply could remain under pressure and oil prices firm. This could also start entering inflation calculations with a lag. Under these circumstances the RBI would rather prefer to wait till the August policy when the base effect will automatically be instrumental in bringing inflation down.
Secondly, global uncertainties also played a critical part in the RBI not cutting rates in this policy. While the global markets have ruled out a Fed rate hike after the weak NFP data, Yellen has kept the markets guessing. Cutting rates at this point of time would be tantamount to second guessing the likely guidance by the Fed. There is also the major risk of BREXIT which goes to a referendum on June 23rd. The BREXIT lobby has been gradually gaining ground in UK and if they choose to leave the EU then the Pound could get hammered. The RBI would rather observe the repercussions before taking a rate decision.
Transmission is also the missing link…
The policy has clearly enunciated that transmission continues to be weak. Out of the 150 bps of rate cuts since January 2015, just about 70 bps has been passed on to the end user. The RBI feels that this defeats the basic purpose of rate cuts. With banks shifting to the marginal cost lending rate (MCLR), transmission is likely to be more seamless in future. Also the ongoing Asset Quality Review (AQR) will ensure that banks have greater freedom to lend at the marginal cost of funds.
In a way, the RBI has done the right thing by maintaining status quo on rates. There are too many X-factors including the FOMC outcome, BREXIT vote, inflation, oil prices, rate transmission etc. By the end of July there will be much greater clarity on all these factors. Probably, at the next policy review on August 09th, the RBI could have a strong case for a rate cut.
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