‘Inflation Concerns Led RBI To Hold Rates, Shift Policy Stance To Neutral’

The decision to keep the policy rate unchanged and the change in stance from accommodative to neutral is based on a judicious assessment of risks going forward....The focus on the medium-term inflation target of 4 percent and the emphasis laid on a durable inflation trend will be growth supportive. The policy reflects the need to balance inflation and growth dynamics that will provide long-term stability.

The shift in stance to neutral from accommodative with a status quo on policy rates should allow RBI, going forward, the flexibility to ease rates to push for stronger growth, amidst government's fiscal rectitude.

Given the general environment of uncertainty both domestically and abroad, the RBI decision to maintain status quo was on expected lines. RBI view is right that monetary policy transmission will improve further if NPAs are resolved, capital position of banks improves and small savings rates are more market driven. 

While we understand that the RBI is perhaps holding up for the current liquidity with banks to get transmitted in the system, our sense says 25 – 50 bps rate cut over the next six months should provide some respite to corporate India on the cost of funds and it may trigger them to start investments. So in summation the interest rate scenario should change for good in FY18.

The impact on bond markets has been quite severe. We've seen the largest sell-off after 2013 when the MSS was hiked by 300 basis points. The bond yields are up 25-30 basis points. The way things are going to pan out, there could be still more pain going forward. The bond markets might stabilise here. The 10-year bond is around 6.75 percent, but that is still 30-35 basis points from the low that we saw.  

We do not expect any more rate cuts. The repo rate remains at 6.25 percent unless we significant shocks either on growth or significant downside surprises on CPI.

We believe that inflation could be around 4.3 percent in Q4FY18 while it could average at 3.5 percent in H1FY18. While this should provide room for the RBI to cut rates by another 25-50 bps, the cautionary tale would be in the core inflation trajectory which could be sticky around the 5 percent mark. This combination will restrict the RBI's space to cut rates.

The RBI's decision to stand pat while changing its stance suggests that it is now focused on its medium-term target of 4 percent and has become concerned about adverse global conditions (higher global inflation and risk of exchange rate volatility). Looking ahead, we expect inflation to average above its target (at 5 percent in FY18) and thus expect policy rates to remain unchanged at 6.25 percent throughout 2017 against our earlier expectations of a 6 percent terminal rate.  

Cut of 25 bps was widely expected and would have lifted sentiment. At this juncture, post long stint of shrinking economy and then demonetisation, people were postponing the demand. This rate cut was necessary from the perspective of bringing that demand back in the system. Markets would react bit nervously to this stance and we think it will correct marginally, to settle around 8500-8600 levels. From the long term perspective corporate earnings are showing some green shoots as against the weak expectation because of demonetisation. We think this correction should be used as an opportunity to deploy more money in the equity markets from the long term perspective.