conflicts in play into monetary policy

The dilemma on shift into monetary easing.....to pause now (and act later) or start now

The stake holders of the economy are unanimous on the end of monetary tightening cycle but stand divided on shift into monetary easing cycle. So, the question is whether it is now (on 16^th December) or later (in January 2012 policy review). While there is case for not to start the reversal cycle in the midterm review; it makes sense to start it right away given the lag time in market impact of policy decisions. There is great comfort on downtrend in inflation into around 7% by March 2012. There is also greater fear (and risk) of slippage in growth momentum below 7% by then. When there is clarity on the direction of inflation and growth; the focus shifts to adequacy and cost of liquidity to balance growth and inflation around 7% till external sector gets back on its feet. The shortfall of system liquidity is much above RBI’s comfort zone of minus 1% of NDTL; currently at 1.5-2.0% with risk of further slippage into 2.5% by second fortnight of December 2011. There is also risk from other sources that would impact liquidity. There will be additional demand for funds from the Government on slippage in fiscal deficit into 5.5%. RBI may need to buy rupees from the system (and sell dollars) to prevent rupee overshoot beyond all time low of 52.73. The risk of extended weakness in rupee into 54.00 is very much valid and it would need rupee liquidity to arrest weakness beyond 54 into 56-58. It is not possible for RBI to increase the quantum of OMO bond purchases over and above its week-on-week supplies; which would drive bond yields sharply down. Given these market dynamics at this stage; it is not unfair to expect RBI to start the monetary easing cycle right now through delivery of 50 bps CRR cut effective 17^th December 2011. The market has already priced in 50 bps CRR cut both in Bond market and Equity market. The sharp reversal in 1Y bond yield from 8.85% to below 8.25% and 10Y bond yield from 9.0% to below 8.5% is reflective of CRR cut now and start of rate cut by January 2012. NIFTY also reacted positively with sharp rally from below 4650 to 5100 before external cues pulled the market down below 4850. So, it is important for RBI to deliver the market expectation and avoid sending unpleasant surprises during thin mid December market. Having said these, it may not send the market into bearish mode if RBI provides directional guidance on start of easing cycle (without delivery of CRR cut) as it did before (in October 2011 policy) for shift into pause mode. So, this brings the case to RBI’s comfort level on current price action in the Bond market. Is the rally in 10Y bond yield below 8.5% considered excessive? Obviously, the answer is affirmative; hence RBI may prefer giving a correction into the market by not starting the easing cycle now. So, odds are even at this stage and it will be safe to conclude that while there is need to release liquidity through CRR cut; it is necessary to get the market into stability (unwinding excessive gains) through not doing it now. This is bad news for stock market to drive NIFTY into 4650 but given the comfort into the near term; it would attract investor’s interest for quick revert back to 5150. The delay in shift into monetary easing cycle will be good for rupee to delay the extended weakness into 54. Over all, RBI can afford to allow liquidity squeeze of 2.0-2.5% of NDTL (up to Rs.1.5 Trillion) if it could help cushion rupee weakness. It is getting complex with lot of conflicts in play; it is better to stay neutral and is important for investors to stay square into monetary policy by unwinding long bonds and square short equities. The market is expected to get into stability mode thereafter with 10Y bond yield around 8.5%; NIFTY at 4650-5150 and USD/INR at 51.50-53.50.

Moses Harding