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A Cautious Reserve Bank Of India Holds Back

The RBI might not be finished with its easing cycle and current conditions may have merely delayed them

(Source: Freepik)
(Source: Freepik)

This credit policy was supposed to have been special. And special it was as the Reserve Bank of India surprised the market by maintaining status quo on all the monetary policy variables.

The assessment comes from an understanding that while the near-term implications on growth from demonetisation are negative, the longer term implications are unclear, but more importantly, might turn out to be limited. On the other hand, guidance on inflation dynamics is distinctly hawkish with the upside risk to inflation maintained, though at a lesser degree from the previous policy.

The economic backdrop in the run-up to the policy was fraught with confusion with regard to the consequence of the demonetisation effect on real economy variables such as growth and inflation. Thus, to an extent, the action was inherently a derivative of the understanding of the RBI with respect to these variables.

  • On growth, RBI’s assessment is that the short-run negative implications on economic activity in cash sensitive sectors would be nullified with progressive increase in cash circulation and shifts to digitized forms of payment
  • The compression in growth due to the negative wealth effect, in RBI’s assessment, is limited
  • Consequently RBI reduced its growth estimate from 7.6 percent earlier to 7.1 percent now

On the inflation front, RBI maintained its projection of 5 percent for Q4 FY17, assessing that demonetisation could temporarily shave off only 10-15 bps off from headline consumer price inflation. This is on the back of an understanding that discretionary spending, which constitutes only 16 percent of the CPI basket, could be affected by demonetisation.

The global side is also likely to be important in assessing the inflationary momentum in the economy. This comes from the recent increases in oil prices and the dollar strength affecting emerging market currencies. With the rupee depreciation, the pass-through of this on domestic inflation would also need close assessment.

There is another factor that could have been a determinant for this policy action. The US Fed is most likely to increase its benchmark rate this month. While this is largely factored in, the critical issue would be the language of the Fed and the assessment of the extent of hawkishness. Given the anticipated fiscal push promised by Donald Trump, it would be critical to evaluate the extent to which the terminal interest could rise in the US.

With the recent sharp drop in the India 10-year yield and a rise in the US 10-year yield, the gap between the two has fallen to a very slender 3.8 percent, compared to historical levels of around 5-6 percent.
A Cautious Reserve Bank Of India Holds Back

The momentum in the India 10-year yield was contrary to the trend in yields across other emerging markets. This was also probably leading to foreign investor selling in debt market, where the outflows from the debt segment have amounted to $2.8 billion from November 9th till date. Cumulative outflows from the debt and equity market amount to $7.8 billion. This factor and uncertainty could have also led to the RBI moving into a cautious wait and watch mode.

Where Are We On The Interest Easing Curve?

First, there is nothing in the policy that might lead us to believe that the RBI has abandoned its “neutral stance” of liquidity, even as it has rolled back the incremental 100 percent cash reserve ratio (CRR) rule. The RBI now has more tools such as the market stabilization scheme (MSS) to manage the system liquidity.

Our own inflation estimates indicate a reading of headline CPI at 3.65 percent for November, but rising to close the year at 4.6 percent. The average inflation reading in Q4 FY17 is at ~4.5 percent, lower than the RBI’s expectation of 5 percent.

Thus, the RBI might yet not be finished with its easing cycle, and the current issues at home and abroad could have merely delayed them.

However, even as we continue to see the RBI reducing the repo rate by a further 25 bps, the probability of this happening in February might not be an absolute certainty and might be delayed till April. The RBI will continue to assess the emerging landscape – both domestic and global – for any further decision on rates.

Indranil Pan is Group Chief Economist at IDFC Bank Ltd. The views expressed above are his own.

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