India Economy

Hawkish tilt to ‘dovish hold’

B Prasanna | Updated on January 08, 2018 Published on October 08, 2017

The RBI’s language clearly indicates that inflation targets are paramount

The RBI’s decision to leave the rates unchanged was on expected lines. It also substantially revised the growth projection for FY2018 to 6.7 per cent from 7.3 per cent earlier.

Though the revision was expected, the extent to which it has been lowered has come as a surprise. While the markets were expecting a “dovish hold” in this policy, the rhetoric accompanying the policy had a hawkish tilt, which was further reinforced in the post policy communication.

The reasons for qualifying this as hawkish are manifold. First, the policy indicates a significant departure in the growth narrative as compared to the August policy that had professed significant concerns about growth.

The RBI characterises the growth slowdown as broadly transient and has taken comfort from the most recent high-frequency indicators like auto sales, core sector growth and PMI prints of August and September that were better than the previous months. It remains optimistic about the medium-term growth trajectory even while acknowledging that the negative output gap might have widened.

Inflation, headline CPI

Second, the Monetary Policy Committee (MPC) has revised the inflation projection higher for the second half of FY2018 from 4-4.5 per cent earlier to 4.2-4.6 per cent. Several factors, identified as constituting upside risks to the inflation trajectory, need to be considered to evaluate the path, going forward.

It was surprising that the MPC chose to revise inflation even though the extent of the revision can be characterised as minor. The MPC has seen the growth slowdown as temporary and driven by supply side factors rather than demand side factors. Therefore, it has not highlighted any possible downside risks to inflation if the growth slowdown should become more protracted.

Third, the RBI, in its post policy communication, seemed to indicate that it is using the March 2018 inflation estimate for headline CPI as the relevant metric for the real rate. This means that the regulator is not likely to look through the one-off impact from HRA hikes as was previously supposed.

Moreover, temporary pricing anomalies due to teething problems related to GST could also continue to show up in higher core inflation prints. We expect March 2018 CPI to be within the RBI’s revised range for H2 FY2018.

Fourth, some parts of the market were expecting the RBI to acknowledge that “flexible inflation targeting” means that the policy can be tweaked to accommodate concerns on growth as long as inflation was within the MPC’s comfort zone.

However, the language of the policy now clearly indicates that inflation targets are paramount and unless concerns on growth and other macro variables adversely affect expected inflation, the RBI is unlikely to move on rates. It seems that the space for further accommodation is limited.

Finally, for the bond markets in particular, tweaking the short sale regulations to allow notional short sale, weekly state loan auctions, incessant supply of bonds with renewed concerns on fiscal slippage/profligacy and the concerted liquidity sterilisation operations through OMO sales could exert upward pressure on yields.

All the above do not take away from the possibility of inflation under-shooting RBI projections and/or continued GDP growth slowdown. These factors, along with the fact that in the eyes of the international investors real yields are on the higher side, will act as a ceiling for bond yields.

‘Rupee positive’ policy

With limits for FPIs opening up substantially for both government bonds and corporate bonds, we could see substantial inflows into bond markets at a time when the RBI has been seen preventing a sharp rupee appreciation.

This policy is surely a “rupee positive” policy. If it continues to encourage exporters to hedge and importers to remain unhedged, the trend of substantially high intervention need by the RBI is likely to continue. The caveats to this view are the strengthening of US dollar and hawkishness of global central banks. The RBI has also recommended the banking system move to an external benchmark-driven anchor for deposit and lending rates, which is likely to have far-reaching consequences for the financial markets and banking system activities.

The writer is Group Executive and Head-Global Markets Group, ICICI Bank

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