Midterm reveiw of monetary policy - some thoughts

The dilemma ahead of midterm review of monetary policy

RBI has done well so far to achieve the immediate objective of bridging the negative gap between growth and inflation. It had to resort to series of rate hikes since March 2010 by pushing operative policy rate from 3.25% to 8.5% to guide headline inflation from above 9.5% to 7.0% with resultant impact of downtrend in growth momentum from over 8% to 7.0%. The expectation now is that both GDP growth and WPI inflation numbers will meet around 7% by end of FY12.

The next agenda for RBI (into FY13) is to arrest downtrend in growth momentum below 7% while driving the headline inflation below 6% which could build investor confidence to support and provide momentum to maintain GDP growth above 7% till emergence of support from external sector. RBI was seen prepared for rate reversal action post delivery of 50 bps CRR cut (on 24^th January) taking comfort from strong rupee and steady commodity prices despite concerns on elevated core inflation. There is already strong headwind to downtrend in inflation from supply side pressures with robust domestic demand despite tight liquidity and high cost of liquidity while the ability of the Government to address fiscal issues is in doubt. Now, higher crude oil price is emerging as major hurdle to put RBI in dilemma on whether or not to shift its stance from neutral to growth supportive monetary policy. RBI cannot afford to shift to growth supportive stance at the cost of inflation that would once again open up negative gap between growth and inflation. Crude oil price is already up by 15% since start of February and underlying bullish tone is strong for extended gains beyond 115 and RBI will take this impact on inflation before shift into growth supportive monetary stance.

RBI would continue to stay concerned both on inflation and growth going into FY13 and as of now bias seems to be on inflation. The external factors are not expected to turn growth supportive in the near future. While RBI’s priority would be to guide inflation into its tolerance level of 4.0-6.0%, it is also important to support the Government in its efforts to address fiscal issues through growth supportive monetary policy. The ability of the Government to address fiscal deficit from the cost side is limited and it is important to quickly ramp up revenues to bridge gap. Given these complexities, it is expected that RBI would continue to focus on liquidity and cost of liquidity. The domestic system is short of rupee funds to the tune of Rs.1.5 Trillion (approx 2.5% of NDTL) against RBI’s comfort of 1% of NDTL. The liquidity situation has not improved despite 50 bps CRR cut and series of OMO bond purchases to the tune of Rs.1 Trillion. The liquidity shortage has become structural issue; hence it is safe to assume that RBI would deliver the next round of 50 bps CRR cut on 15^th March. The cost of liquidity which is very high at 10.25-10.75% across 1-12M tenor is a concern and infusion of Rs.32K Crores through 50 bps CRR cut may not make significant impact on short term money market rates. Nevertheless, the current liquidity pressure being considered temporary till last week of March 2012, RBI may not opt for providing relief at this stage through rate cut. It would be prudent to wait till positive outcome from Union Budget FY13 and possible reversal in NYMEX Crude from $115 (into $95) before trigger of rate cut action. Over all, with lack of clarity on two critical factors of fiscal deficit and crude oil price, RBI will like to keep things simple by delivery of 50 bps CRR cut while keeping policy rates unchanged.

The impact on medium/long tenor bond market may be significant; CRR cut without rate cut is considered negative for the Bond market at this stage with the fear of reduction in OMO purchases. 10Y bond yield eased from 9% to 8.10% on aggressive OMO purchases by RBI despite supply side issues which would extend into FY13. The current negative spread between 1Y and 10Y bond yields (1Y at 8.50% and 10Y at 8.20%) is expected to reverse with downtrend in 1Y yield into 8% and uptrend in 10Y yield into 8.5%; reversal from there will depend on shift of operative policy rate from Repo rate to Reverse Repo rate or start of rate reversal cycle. Over all, shift into FY13 is expected to be good for Money and Bond market as RBI is expected to maintain adequate system liquidity at affordable cost to support growth momentum to set up bullish undertone in stock market and ensure higher revenue collections to arrest slippage in fiscal deficit beyond 5% of GDP.

Moses Harding