feeling RBI's pulse ahead of midquarter policy review

Will RBI shift priority to growth and deliver 50 bps cut in CRR and policy rates?

The expectation build-up of shift into aggressive growth supportive monetary policy, post weak GDP/IIP data; sharp fall in crude oil price and rupee stability below all-time low with signs of appreciation pushed Money Market rate curve down; 3-12M curve at 9.0-9.5% from 9.75-10%. 10Y Bond yield was sharply down to 8% on the new 10Y Bond from coupon cut-off at 8.15%. The party was gate crashed by bad inflation data; headline for May at 7.55% (core below 5%) which sent bond prices crashing down on dilution in expectation of 50 bps rate cut. How will RBI react to this bad set of data on growth and inflation? RBI as custodian of monetary system has multi-tasking role to play. It has to control inflation and money supply; ensure sufficient system liquidity at affordable cost; flow of liquidity to desired sectors; maintain monetary system as support to growth; control over cost of Government borrowing; manage FX impact on monetary system etc. It is not an enviable role when the operating environment is tough driven by weak domestic and global cues with limited support from the political system.

RBI will closely watch expectation (and trend) on headline (and core) inflation and money supply before shifting into its secondary role of extending support to growth. The money supply is already down and the system has huge capacity to absorb cash without hurting inflation. The pressure on inflation will moderate on low growth, extended reversal in BRENT Crude and release of pressure on rupee. These factors supported by release of supply-side concerns due to good monsoon and administrative measures from the Government should provide relief. On the other hand, growth pressure is severe with FY13 estimates moving below 6% and monetary environment not conducive to spur domestic investments. Over all, downside risk to growth is much higher than upside risk to inflation; though the expectation (and the trend) on growth and inflation may be assumed to be neutral (and mixed), chances of headline inflation moving below 6% is higher than pickup in growth momentum above 6%. This triggers the need to get into next round of monetary easing despite inflationary concerns staying valid into the near term. Moreover, there may not be resolutions to fiscal consolidation when growth is under pressure.

The expectation now stands diluted to 50 bps CRR cut and 25 bps cut in policy rates from earlier 50 bps across all. It is possible that RBI covers this up with 75 bps CRR cut as the need to conduct OMO bond purchases is diluted driven by stable rupee and low bond yields, 10Y yield below Finance Ministry’s tolerance level of 8.20%. This should provide price stability in 10Y Bond (8.15% 2022) yield at 7.95-8.20%. This range is valid till operative policy rate stays at higher end of LAF corridor of 6.75-7.75% (on assumption that 25 bps rate cut as given) and the risk of weakness into 8.15-8.20% will be valid on pipe-line bond supplies without OMO bond purchases. Beyond there, the next trigger will be on shift of operative policy rate from 7.75% to 6.50% (with another 25 bps rate cut) on or before September mid quarter review through combination of CRR cuts and OMO bond purchases. This move will be dependent on removal of stagflation risks driven by sharp fall in inflation and moderation in growth. Let us review this position as we move into July quarterly review and it is considered good to stay invested (10Y at 8.10-8.20%) ahead of shift of system liquidity from deficit to surplus which would then trigger 10Y yield below 8% into 7.65-7.50% before end of 2012.

The risk factor to this expectation is that of delivery of CRR cut without rate cut which will drive money market rates and bond yields much higher. The system is short by over Rs.1 Trillion (approx 1.5% of NDTL) and delivery of 50-100 bps CRR cut (without rate cut) will continue to keep operative policy rate at current level and resultant cut in OMO bond purchases will further add to bearish set up. It is important for RBI to manage liquidity injection through combination of CRR cut and OMO till most of government borrowing is out of the way.

To conclude, we will set a 51% probability for 50 bps CRR cut and 25 bps rate cut and 49% probability for 50 bps CRR cut and 50 bps cut in Repo and Reverse Repo rate. Either of these actions will provide price stability in 10Y bond yield at 7.95-8.15%; 50 bps rate cut into the lower end and 25 bps rate cut into higher end; test/break either-way not expected to sustain. It would be painful if RBI delivers 50-75 bps CRR cut without rate cut or leave things unchanged. Therefore, there should be action with combination of CRR and policy rate and there is no case for delivery of aggressive rate cut without CRR cuts. Let us see what RBI delivers on 18^th June? Will it play to the gallery (50 bps CRR cut and 25 bps rate cut) or stay conservative sticking to its primary role of containing inflation (50 bps CRR cut without rate cut) or play tune with the ministry to support growth (50 bps CRR cut and rate cut)?

Moses Harding