A 25 bps repo rate cut is on the cards

RBI will most likely continue to use open market operations to manage liquidity

The Monetary Policy Committee (MPC) of the Reserve Bank of India will most likely go for a 25 basis points (bps) cut in the repo rate at its upcoming policy review in August 2017, before taking a pause on further actions on policy rates.

The easing of the CPI inflation below the 2 per cent floor of the inflation target band in June 2017, favourable progress of monsoon and kharif sowing so far and the limited evidence of a knee-jerk rise in prices, post introduction of Goods and Services Tax (GST), will be the key drivers for the likely policy action.

However, the tone of the policy document may exercise caution and not give indication of any further cuts in the near term, given the expected rise in the CPI inflation in H2 FY2018 beyond 4 per cent and the steady hardening of rates in the global markets.

With banking sector credit growth remaining sluggish at 6.1 per cent y-o-y as on July 7, 2017, and deposits at 10.7 per cent over the same period, the systemic liquidity continues to remain in surplus.

The RBI has taken adequate measures to absorb liquidity through instruments such as cash management bills (CMBs), Treasury bills (T-bills) issued under the market stabilisation scheme (CMB) and the recent open market sales of G-Sec.

Despite these measures, a substantial ₹3.4 trillion continues to be absorbed on an average through overnight and term reverse repos in July 2017. As a portion of the continuing surplus in systemic liquidity is structural and not transitory in nature, it warrants permanent measures of absorption such as sales of the RBI’s holdings of G-Sec through open market operations (OMOs).

In addition to the ₹300 billion of OMO sales announced by the RBI since June 2107, a further ₹200-300 billion worth OMOs in multiple tranches may be used to supplement the other existing tools to absorb surplus liquidity.

The OMO sales could marginally push up yields despite the ample liquidity in the system and the likely rate cut by the central bank next month.

The CPI inflation rate is quite favourable at this stage, having declined on a year-on-year (y-o-y) basis to a series low of 1.5 per cent in June 2017 from 2.2 per cent in May 2017, primarily driven by a deeper disinflation in food items (to -1.2 per cent from -0.2 per cent) and a broad-based easing in the previously sticky core CPI inflation (excluding food and beverages and fuel and light; to +3.9 per cent from +4.3 per cent).

Consequently, the CPI inflation has been lower than the midpoint of the RBI’s inflation target band of 4 per cent for eight consecutive months and June 2017 is the first instance when the lower end of the targeted band of 2-6 per cent is being breached.

Limited scope for more cuts

The monsoon dynamics, which has been reasonably favourable so far, has boosted sowing of most crops. In addition, the prices of many food items like pulses, vegetables (barring tomatoes) and oils remain weak on a seasonally adjusted basis so far in July 2017. However, a reversal of the favourable base effect is not ruled out, which could result in a sharp rise in food and headline inflation, and exceed 4 per cent during H2 FY2017.

With the implementation of the GST, its final impact on inflation will be watched keenly as businesses would prefer to observe the impact of GST on costs for some time before they raise prices.

At the same time, the revision in house rent allowance (HRA) of Central government employees with effect from July 1, 2017, is likely to push up housing inflation, though its impact would be staggered over FY2018 and the first quarter of FY2019.

It is expected that the CPI inflation will remain below 2 per cent in July 2017, before rising above 4.0 per cent during H2 FY2018, partly led by the reversal of the favourable base effect. This expected rise in CPI inflation amidst hardening of rates in the global economy could limit scope for further rate cuts for the rest of the fiscal.

The writer is MD & Group CEO, ICRA Ltd

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