The Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI) may reduce the repo rate by 25 basis points (bps) at its upcoming policy review in August 2017, according to credit rating agency ICRA.
It added that there is a low likelihood of further rate cuts in the second half of FY2018.
However, the decision is unlikely to be unanimous and the tone of the policy document may not signal that further cuts would be forthcoming, the agency said. In addition, the RBI is likely to indicate that additional open market operations would be conducted to manage the prolonged liquidity surplus.
Naresh Takkar, Managing Director and Group CEO, ICRA, said: “With the CPI inflation easing below the 2 per cent floor of the inflation target band in June 2017, a reasonably favourable progression of the monsoon and kharif sowing so far, and limited evidence of a knee-jerk rise in prices following the imposition of the goods and services tax (GST), there is a high likelihood that the MPC would vote to reduce the repo rate by 25 bps in their upcoming meeting.”
However, the expected rise in the CPI inflation in the second half (H2) of FY2018 is likely to contribute to a lack of consensus in this vote to cut the repo rate, and infuse caution in the tone of the policy document regarding the possibility of future rate cuts, he added.
Given that a portion of the continuing surplus in systemic liquidity is structural in nature, Takkar felt that this would warrant permanent measures of absorption such as sales of the RBI’s holdings of Government securities (G-sec) through open market operations (OMOs).
In addition to the Rs 20,000 crore of OMO sales announced by the RBI over the last month, ICRA expects further OMO sales of Rs 30,000-40,000 crore in multiple tranches, to supplement the absorption of surplus liquidity through other short-term tools.
The agency assessed that the likelihood of further OMO sales of G-secs is expected to push up yields to some extent, partly offsetting the impact of the anticipated 25 bps rate cut.
The year-on-year (YoY) CPI inflation declined to a series low of 1.5 per cent in June 2017 from 2.2 per cent in May 2017, led primarily 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).
While the CPI inflation has undershot the midpoint of the RBI’s inflation target band of 4 per cent for eight consecutive months, June 2017 is the first instance of the lower end of the band of 2-6 per cent being breached.
The agency said: “The monsoon dynamics have been reasonably favourable so far, which has boosted the sowing of most crops. Moreover, prices of a number of food items such as 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 could result in food and headline inflation rising sharply, and exceeding 4 per cent during H2 FY2017.”
ICRA expects the final impact of the GST on inflation to become clearer with a lag, as businesses would observe the impact of this tax on costs over a period of time, prior to raising prices.
Although the revision in house rent allowance (HRA) of Central Government employees with effect from July 1, 2017, is likely to push housing inflation up, its impact would be staggered over FY2018 and the first quarter of FY2019.
ICRA expects the CPI inflation to remain below 2 per cent in July 2017, before rising above 4 per cent during H2 FY2018, partly led by the reversal of the favourable base effect. Accordingly, there is a low likelihood of further rate cuts in H2 FY2018.
Despite measures taken by the RBI 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, a substantial Rs. 3.4 lakh crore is being absorbed on an average through overnight and term reverse repos in July 2017.
ICRA maintains its view that a portion of the continuing surplus in systemic liquidity is structural and not frictional in nature, warranting permanent measures of absorption such as sales of the RBI’s holdings of G-sec through OMOs.