‘A Cautiously Dovish Monetary Policy’

The first bi-monthly monetary policy for financial year 2017-18 by the Reserve Bank of India's (RBI) Monetary Policy Committee (MPC) can be described as cautiously dovish.

While the broad policy stance remains “neutral”, the policy certainly signals mild easing. This is because the penal rate at which banks borrow money from RBI – the Marginal Standing Facility (MSF) rate has been lowered by 25 basis points (bps) from 6.75 percent to 6.50 percent; and the reverse repo rate – the rate at which banks park their surplus with the RBI by purchasing the securities from the RBI – has been raised by 25 bps from 5.75 percent to 6.00 percent. A reduction in the interest rate corridor from 100 bps to 50 bps implies lesser volatility in the short-term inter-bank rates and lesser incentives for banks with surplus liquidity to hoard it for a longer time. This will not just help in anchoring the money market rates closer to the policy rate, but also help banks in managing liquidity prudently, and ride out a plethora of uncertainties created by unexpected movements in capital flows and government cash balances.

The relevant policy rate today is the reverse repo rate, given the state of excess liquidity and hence, we expect short term money market rates to hover near 6.00%, in the days to come.

The move is particularly appropriate in the current extraordinary circumstances created by the radical measure of demonetisation. The market mood was nervous ahead of today's policy announcement, as market participants were expecting the RBI to use a more disruptive and broad-brush measure like the cash reserve ratio (CRR) to suck out excess liquidity from the banking system. This move would have further reduced banks' net interest margins which are already reeling under the pressure of high credit costs and bad loans.

At the same time, the policy is cautious in its tone. The RBI's top officials clearly said in their press interaction that the central bank will use all the tools at its disposal, like the market stabilisation scheme, long tenor variable rate reverse repos and open market operations to manage liquidity in the coming quarters. The RBI expects surplus liquidity to steadily moderate over the next three to four quarters.

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Risks On Growth And Inflation

So far as domestic macros are concerned, the RBI sees a modest improvement in the growth outlook, primarily on the back of improved food grains production, recovery in exports and a pickup in a few industrial sectors. However, it remains concerned over the prospects for investment and rural consumption demand. In its statement, the RBI has highlighted that a sizable under-utilization of capacity in several industries could operate as a drag on investment. While an improving global environment augurs well for India's growth outlook, the RBI sees downside risks stemming from the possible out-turn of the south-west monsoon, further hardening of commodity prices and ebbing consumer optimism - as captured by the RBI's own consumer confidence survey in March 2017. The RBI has, however, kept its gross value added (GVA) growth projection unchanged at 7.4 percent in FY17, versus 6.7 percent in FY16, perhaps as the best case scenario.

On the inflation front, the RBI sees no material difference in inflationary impulses today from its previous policy statement. The central bank is pretty confident that Consumer Price Index (CPI) inflation will under-shoot its target of 5 percent for the January-March 2017 quarter (Q4FY17), in view of the recent sub-4 percent readings for January and February 2017. However, it sees several upside risks to CPI inflation in FY18, which may stem from:

• A rising probability of sub-optimal rains;
• Payment of house rent allowance as recommended by the Seventh Central Pay Commission;
• Any one-off effects of the GST implementation;
• The hardening trajectory of global commodity prices; and
• Rising budgetary deficits of the central & state governments, taken together.

Hence, the RBI has marginally increased its inflation projection to an average of 4.5 percent in the first half of FY18 (from 4-4.5 percent earlier) and 5.0 percent in the second half of FY18 (from 4.5-5.0 percent earlier).

Given that the retail inflationary trajectory is not worrisome at the current juncture, the RBI has wisely used the space to come out with a non-disruptive monetary policy, even when the surplus liquidity in the banking system is hovering at a very high level, near Rs 4.8 lakh crore. While fixed income players would take some time to understand the policy engineering, we expect today's policy to have a softening impact on the long-term interest rates and the cost of borrowing in the months to come.

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Rupa Rege Nitsure is Group Chief Economist at L&T Financial Services.

The views expressed here are those of the author's and do not necessarily represent the views of BloombergQuint or its editorial team.