Monetary Policy Committee Firmly Focussed On Inflation

The outcome of the first meeting of the monetary policy committee (MPC) in the new financial year was largely along expected lines. The MPC kept the repo rate unchanged at 6.25 percent, in line with its neutral policy stance and continuing vigilance on inflation, given the 4 percent target.

In order to ensure surplus liquidity in the banking system does not lead to short-term rates being consistently lower than the policy rate, the MPC narrowed the rate band for the Liquidity Adjustment Facility (LAF). This was done by increasing the reverse repo rate by 25 basis points (bps) to 6 percent and cutting the Marginal Standing Facility (MSF) rate by 25 bps to 6.5 percent. The LAF rates corridor now stands at -/+ 25 bps around the repo rate from -/+ 50 bps earlier. The Reserve Bank of India (RBI) will now remove excess liquidity in the banking system between 6-6.25 percent instead of 5.75-6.25 percent earlier.

Addressing Surplus Liquidity

With a build-up in bank deposits post demonetisation, money market rates have anchored more closely to the reverse repo rate, which stood at 5.75 percent earlier, than the policy rate of 6.25 percent. While the surplus has gradually reduced from its peak in January following the ongoing remonetisation, it remains well above the neutral level of liquidity which the RBI endeavours to maintain in the banking system. The comfort band for liquidity is +/- 1 percent of the banking system's Net Demand and Time Liabilities (NDTL). A neutral level within this comfort band is not clearly defined but is a function of the policy stance, which is turning less accommodative. The overhang of liquidity can get exacerbated by sterilised intervention by the RBI in the foreign exchange market on the back of robust capital inflows. Thus, considering that the surplus liquidity conditions are likely to persist for another 2 to 3 quarters, the narrowing of the rate corridor would help ensure that short-term rates are now higher and consistent with the policy stance and rate.

Also Read: ‘RBI Clears The Air On Liquidity'

Noting these developments, the policy statement lists out all the instruments at the disposal of the central bank to absorb excess liquidity over various time horizons. The statement also mentions that a Standing Deposit Facility (SDF), an uncollateralised facility for banks to park excess liquidity, is currently being discussed with the government and its introduction will complete the toolkit.

Optimism On Growth

The move comes at a time when the RBI and the MPC are turning optimistic on growth. In its assessment of growth, the monetary policy report charts a path of recovery in gross value added (GVA) growth from 6.7 percent in the financial year 2016-17, to 7.4 percent in FY18, and further to 8.1 percent in FY19. The risks around this baseline growth trajectory are seen evenly balanced.

Factors seen driving growth higher are:

• Revival in demand led by remonetisation;
• Pass-through of past rate cuts to lending rates;
• Greater capital expenditure by the government;
• Structural reforms like GST; and
• A favourable global growth environment.

The recent round of the RBI's own industrial outlook survey supports this view in the near term, and the policy statement indicates that the negative output gap will close gradually.

A revival in growth and demand over the current fiscal is likely to add to the pressure on inflation.

Risks On Inflation

The MPC has reiterated its commitment to achieving the 4 percent consumer price index (CPI) inflation over the medium-term. A conservative approach on inflation is reflected in the projection of CPI inflation of 4.5 percent in the first half of the current financial year before it rises to 5 percent in the second half. The risks here are seen on the upside. This projection is somewhat higher than the projection made in February and is prone to a positive surprise at least in the first half of the year.

Baseline inflation projections assume:

• A normal monsoon in 2017;
• Oil prices at an average of $50 per barrel in FY18; and
• Government achieving its fiscal deficit target.

Persistent core inflation at close to 5 percent remains a concern. Upside risks to the forecast are seen from:

• Weaker than expected monsoons;
• Impending house rent allowance hike for central government employees;
• Possibility of higher commodity prices; and
• Global financial market volatility leading to a weaker rupee.

The MPC has also specifically noted that the level of general government deficit – already high compared to other emerging markets – will be exacerbated by state farm loan waivers. It took an unfavourable view of such measures, which weaken credit culture, among other things.

Aslo Read: Consumer Confidence, Inflation Expectations Take A Turn For The Worse, Show RBI Surveys

The overall narrative around inflation seems to have become more watchful compared to the February policy. That, in turn, has necessitated a measure for pricing excess liquidity more appropriately. With bank credit offtake weak, liquidity overhang has not yet had an impact on inflation. The MPC, going forward, would therefore carefully watch the pace of credit growth too, along with the risks it enumerated on inflation.

With future action now data dependent, the MPC is likely to remain cautious and await more information to decide whether the risks to inflation have indeed dissipated sustainably or not.

In the meantime, a “prolonged pause” on rates will remain the main course of action with active management of evolving liquidity conditions.

Measures To Tackle NPAs

In an important development related to the resolution of the non-performing assets (NPAs) in the banking system, the central bank has indicated that they would soon be introducing various measures to tackle non-performing loans. The current set of instruments available has proved inadequate in addressing the problem of bad loans. The pile of non-performing, restructured, and stressed assets touched 16 percent of total advances in December 2016, opines the Economic Survey. This is now seen as the biggest challenge to revive investment activity and growth, with talks around a publicly-owned asset reconstruction company growing. A comprehensive mechanism to deal with NPAs will help buttress growth and investor confidence.

Also Read: ‘A Cautiously Dovish Monetary Policy'

With the MPC reiterating a neutral stance coupled with a close vigilance on inflation, along with the endeavour to move to neutral level on liquidity, bond yields are likely to witness some upward pressure. The move is, however, favourable for the rupee, which has been bolstered since mid-February by foreign portfolio inflows, with March witnessing total inflows worth $10.5 billion. Growth revival along with a commitment to controlling inflation will be seen in a positive light by global investors and support further inflows. The RBI, by narrowing the corridor, has therefore positioned itself to deal with a surge in capital inflows and may turn more tolerant of a stronger rupee.

Gaurav Kapur is the Chief Economist of IndusInd Bank. Views expressed herein are personal.

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

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