Monetary Policy holds rates but silent on liquidity management…

The Monetary policy announced by the RBI at the end of the 2-day Monetary Policy Committee (MPC) meeting on 06th April was largely along expected lines. The repo rate was maintained at the exiting level of 6.25%. Surprisingly, there was not much of a discussion on new measures to manage the surfeit of liquidity in the financial system. Here are the key takeaways from the Monetary Policy Announcement on 06th April…

What were the key takeaways from the RBI Monetary Policy Review?

  1. The monetary policy in April was announced at a time when there was a high degree of uncertainty; both in terms of domestic inflation and in terms of global interest rate clues. CPI inflation had seen a sharp up-move in the last couple of months on the back of higher non-core inflation. On the global front, the focus was on the Fed and its rates trajectory.
  1. As expected the RBI chose to keep the repo rates at the exiting rate of 6.25%. However, the RBI has further compressed the yield spread between repo rates and reverse repo rates. The yield spread now stands reduced from 50 bps to 25 bps. This reduces the bank rate from 6.75% to 6.50% despite the repo rates remaining static. This spread was reduced from 100 bps to 50 bps last year.
  1. The policy has expressed reservations over the sharp rise in inflation. In fact, the RBI has acknowledged that inflation could move up to the 4.5% level in the first half of the year and further to 5% levels in the second half of the year. This was one of the key reasons for the RBI maintaining the status quo on rates.
  1. RBI has also acknowledged in the policy, the distinct shift towards tighter monetary stance of the central banks. The US has started hiking rates and the UK could start soon too. Both Europe and Japan have tacitly called an end to the rate easing scenario. This indicates a clear shift of central banks towards increased monetary tightness in the months and quarters to come.
  1. RBI has also expressed a concern over the Fed action in the next few months. There are 2 points to understand here. Firstly, the FOMC may have 2 or 3 rate hikes during the year. However, the bigger worry is that the US Fed may look to start tapering its massive bond portfolio of $4.5 trillion. That is likely to create a global squeeze in liquidity, impacting economies across.
  1. The big challenge that has not been addressed in-depth in the policy was the management of liquidity. The Indian financial system currently is flush with liquidity to the tune of Rs.400,000 crore. The RBI has been selling securities aggressively to absorb this liquidity but that has the impact of increasing the debt of the government.
  1. Another method of handling this liquidity surplus is through CRR hike, but that has implications for cost of funds of Indian banks and the RBI may not be keen at this juncture. Another option being considered is the Standing Deposit Facility (SDF), where the liquidity can be absorbed without issuing securities and increasing the debt of the government. The policy has dealt with the entire issue of liquidity management in a very brief manner. In fact, the policy has no mention of the SDF, which strongly expected to be included as an option in the policy.
  1. Going ahead, the RBI sees distinct risks to inflation stemming from non-core inflation impacted by higher oil prices. Also, the food inflation is likely to take a hit if the El Nino tends to depress the monsoon by 5% below average, as per the SKYMET predictions. Combined with a glut of liquidity already in the system, the RBI is obviously seeing distinct upside risks to inflation in the coming year and that explains their caution on rate cuts.
  1. Another factor that could impact the RBI stance on rates is the global rates scenario. If the Fed hikes rates another 3 rounds this year, then the yield spread between the US 10-year benchmark and the Indian 10-year benchmark may come down substantially. This could impel many FPIs to actually prefer the safety of US bonds compared to Indian bonds. In fact, this trend can become more pronounced if the INR also weakens simultaneously.
  1. Will the RBI cater to the needs of the industry by giving a rate cut going ahead? That looks highly unlikely for 2 reasons. Firstly, the demonetization resulted in a sharp cut in the MCLR as a result of which transmission is already over 100%. Secondly, the RBI has effectively cut rates by 25 bps by reducing the spread between the repo rates and the bank rate. That should be a good starting point, if growth is to pick up in response to lower rates.

Things will be a lot clearer once the actual minutes of the MPC come out on April 20th. That will give greater clarity on the individual member’s thought process behind this status quo decision. Interestingly, for the fourth time in succession, the 6 members of the MPC have been unanimous in their decision. It may be recollected that in the October 2016 MPC meet, all members had agreed to a 25 basis points rate cut. In the three subsequent MPC meets, there was unanimity in maintaining status quo on rates. Hopefully, there should be greater clarity on the domestic inflation picture as well as the global rates trajectory by the time the RBI announces its next monetary policy on June 06th.

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