By Invitation. Prolonged pause on policy rates likely

The RBI’s April monetary policy was eagerly awaited by the markets for anticipated steps on liquidity management. In this context, the narrowing of the policy corridor was a welcome development as it achieves several objectives at one go.

The practice of narrowing the corridor was recommended by Urjit Patel in a report published in 2014. This will help in finer alignment of the operating rate to the policy rate. It has the added advantage of aligning the money market yields with the stated stance. By raising the floor and lowering the ceiling of the corridor, the RBI has ensured that the range in which market rates move is also compressed, hence curbing the volatility.

In the run-up to the policy, uncertainty regarding the possible introduction of a Standing Deposit Facility would have disincentivised deployment of funds into term reverse repo operations. As this was not announced in the policy, flow of funds into term reverse repo is likely to go up. The RBI clarified that the concept of a Standing Deposit Facility is being discussed with the government.

That the cash reserve ratio was kept unchanged is also a pragmatic move as the substantial liquidity overhang in the system is likely to be temporary. Any action on this front would also have had the unintended consequences of a mixed signal to the market on the policy stance.

On balance, the RBI reiterated that it will continue to adhere to its commitment to guide systemic liquidity towards “neutrality” and use all possible tools. The specific addition of open market operations (OMO) sales to the tool kit for sterilising durable liquidity has imparted a slight negative bias to the bond markets. As far as the economy is concerned, the RBI continues to sound vigilant on inflation and highlighted several upside risks to the baseline inflation forecast. Some of the factors that were highlighted were uncertainties surrounding the monsoon, implementation of the 7th Pay Commission awards, one-off effects of GST implementation and elevated levels of the general government deficit. The RBI has also expressed concern about increasing pricing power of corporates as input costs have started rising. The recent trends in global reflation and attendant upside risks to commodity prices were also highlighted.

While the central bank has acknowledged that CPI for Q4 FY2017 will undershoot its 5 per cent target, its assessment of inflation outlook for FY2018 is in line with the change of monetary policy stance to “neutral” from “accommodative” in February.

The RBI had also flagged concerns about inflation expectations while changing the stance in the previous meeting.

In the April policy, it has highlighted the fact that after dipping in December, inflation expectations have actually reversed in subsequent months. The RBI noted that price expectations have started to rise across all product groups. A durable achievement of RBI’s medium term inflation target also requires a sustained fall in inflation expectations, which also seems difficult at the moment. We note that expectations are also adaptive in nature and crystallise only with a lag.

On balance, we continue to expect the RBI to remain on a prolonged pause on policy rates. The explicit guidance provided on systemic liquidity is a positive and will help in better compliance of the stated monetary policy stance. The focus on speedy resolution of stressed assets is also welcome and will help to rejuvenate credit flow in the economy.

On the markets front, the move should lead to a flattening of the yield curve as short-term rates are pushed up on the back of the narrowing of the corridor. Long-term rates would continue to watch the evolving inflation trajectory along with the start of the Government’s borrowing program and for any possibility of OMO sales if it were to fructify.

The Indian rupee has been one of the better performing currencies in the Emerging Market (EM) pack over the past two months. We have also seen significant capital inflows over the past couple of months amid relatively favourable macroeconomic backdrop as compared to its peers. The RBI’s continued vigilance on the inflation front will help to reinforce confidence in the Indian economy and thereby further support capital flows.

The writer is Head – Global Markets Group, ICICI Bank