A welcome streak of independent thinking

Decision to hold rates re-instates RBI as an independent inflation-fighting central bank

The RBI’s latest December policy can be considered a landmark policy in all respects, especially since it was set against the backdrop of volatile and uncertain global and domestic financial markets. The policy decision reinforces the credentials of the RBI as an independent, inflation-fighting central bank and also shows that it will not compromise on the flexible inflation-targeting mandate.

The decision to stay on hold is predicated on the various factors mentioned, such as food prices, trajectory of global crude prices, relatively sticky core inflation and global financial market volatility. However, overall, the policy maintained an accommodative stance while continuing to be supportive of growth.

We also believe that it is possible that the RBI has prudently shifted its concern to the ‘medium’ term inflation target of 4 per cent, given the long and variable lags associated with monetary policy tools. Hence, the upside risks to inflation from factors such as bottoming out of global food prices, prospects of US fiscal expansion, the Pay Commission impact, bear watching.

While growth forecast on a gross value added (GVA) basis has been reduced for FY17 to 7.1 per cent from the earlier estimate of 7.6 per cent, this has been done primarily to account for the slowdown witnessed in the recently released Q2 growth numbers. It is possible that with the benefit of more data available to it, the RBI has concluded that the impact of demonetisation on growth is expected to be transitory. However, we feel that it would also want to analyse future incoming data before taking a call on further easing.

Global factors at play

What also needs to be noted is the role played by global factors in the decision. There are several global events ahead, both political and economic that may cause considerable volatility in financial markets. An environment of imminent tightening of monetary policy in the US, rising bond yields and the strength of the US dollar do not portend well for emerging markets as an asset class. Though India has been a top performer in relative terms, we have also witnessed outflows to the tune of more than $9 billion from October till date. Hence global developments, especially through the channel of financial markets, have duly warranted much more attention on the RBI’s radar than what the markets in India were expecting.

The other development, which will be monitored closely, is liquidity management and the re-emphasis on keeping the banking system liquidity balanced. The RBI sees the liquidity influx to be transitory and has not given an estimate on what it thinks will remain in the system as durable deposits. However, in the near term, the banking sector will continue to witness inflows, which will necessitate using a combination of tools like (adhoc) reverse repos and issuance of bonds under the market stabilisation scheme. This means that the operative rate in the system will continue to be the repo rate.

As an aside, the rollback of the incremental CRR (cash reserve ratio) measure, though expected, was a welcome move. Once the impounded liquidity is released back into the system, transmission of policy signals into rates is likely to be facilitated more smoothly.

Going ahead, we expect the inflation trajectory till the end of this fiscal year to remain comfortably below the RBI’s expectation of 5 per cent. This should create some room for incremental policy easing amid the continuing accommodative stance. However, any incremental policy action has now become significantly contingent on economic data and hence the balance of growth-inflation dynamics will remain crucial for monetary policy trajectory.

What to watch out for

The RBI, at its next policy meeting, will also have the added inputs from the FY 2018 Budget and the Government’s estimates for growth for the whole year. Hence the central bank and the Monetary Policy Committee (MPC) would have more data to judge the ramifications of recent domestic developments. We will also await the MPC’s minutes to ascertain how the Committee views the evolving growth-inflation mix.

As far as bond markets are concerned, the future inflation prints, the Government’s spending profile and borrowing pattern in the Budget, developments in the US and global bond yields would be some of the factors that will be carefully watched for cues.

The writer is Head- Global Markets Group, ICICI Bank

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