By: Punam Sharma
The RBI continued its recent streak of shocking markets by not just not cutting interest rates but explicitly shifting its stance to ‘neutral’ from ‘accommodative’. Key takeaways from the policy and the media call afterwards are as follows:
1. While CPI has undershot RBI’s ‘5% with upside risk’ expectation, it is largely driven by 2 very volatile items: vegetables and pulses. The central bank expects that while pulses prices may remain soft, vegetable prices may potentially rebound as the effects of demonetization wear off. Excluding food and fuel, CPI is stuck around 4.9% since September. This could ‘set a floor on further downward movements in headline inflation and trigger second-order effects’.
2. In terms of future trajectory, the RBI expects CPI to be muted in Q1 2017 – 18 on favorable base effects and ‘lagged effects of demand compression’. But thereafter it is expected to reverse as ‘growth picks up and the output gap narrows’. Base effects also turn adverse from Q3 and Q4. On aggregate, the central bank expects CPI at 4 – 4.5% in the first half, and 4.5% – 5% in the second half of FY 18; with risks evenly balanced.
3. The RBI notes 3 significant upside risks: rising commodity prices, volatility in exchange rates on account of global financial market developments, and fuller effects of HRA component of 7th Pay Commission.
4. The commitment to bringing CPI ‘closer to 4% on a durable basis and in a calibrated manner’ is reiterated. This requires further significant decline in inflation expectations, especially as the services component of inflation that is sensitive to wage movements has been sticky.
1. From an assessed level of 6.9% in current year, the RBI expects GVA growth to recover sharply in the next year. The reasons include: bounce back in discretionary consumer demand, rapid restoration of activity in cash intensive sectors, recent decline in lending rates spurring demand, and impetus from union budget. Given these, GVA is projected to be 7.4% for next year; with risks evenly balanced.
1. The neutral stance has been reaffirmed with the assessment being that surplus liquidity will decline with progressive remonetization. Nevertheless, the current abundant liquidity with banks is expected to persist in the early months of 2017 – 18.
Assessment and Takeaways
The RBI’s explicit change of stance effectively may be considered as marking the official end to the easing cycle. The change has been brought about to emphasize the need to move to 4% CPI on a durable basis in context of a still stubborn core inflation. The RBI and the MPC want to retain flexibility as they assess ‘how the transitory effects of demonetizaton on inflation and the output gap play out’. However, it is unlikely that there are further cuts in the pipeline so long as the broad market (and our) assessment holds true that CPI is unlikely to average below 4.5% for the year ahead. Even if it does, RBI may await confirmation over Q3 and Q4 which is when the MPC expects the maximum pressure on CPI to unfold. This delay may be advisable from another perspective as well: given RBI’s very justifiable concern with global financial risks, they will have more time to assess how these pressures are emerging later in the year.
The RBI’s overall assessment today is very much in line with our view that the rate cycle is broadly at an end. Indeed, we had flagged in a recent note the risk of not taking seriously the revision in RBI’s stance since the December policy (please refer “…But Seriously”, dated 13th January for details). That said, we hadn’t expected that the RBI will put in place an explicit ‘marker’ so soon of a change in its stance.
From a portfolio standpoint, after having played the demonetization rally tactically, our strategy has been broadly focusing on the front end of the rate curve (upto 5 years) across our bond and gilt funds. We believe that these will continue to get anchored to a positive liquidity environment and very low bank deposit rates for the foreseeable future. We remain negative on long duration bonds, a stance which is reaffirmed with the policy today.
Please refer the previous note ‘…But Seriously (1)‘ here: http://www.idfcmf.com/insights/but-seriously/
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