Conflict in Rupee-Inflation dynamics support steady policy rates!?

There is indeed strong (and valid) case for shift to dovish monetary policy stance, which builds up expectation for rate cut sooner than later. RBI's recent guidance indicated rate cut action by late 2015, as the best case subject to meeting certain targets (and objectives); now, expectation stands shifted to early 2015. However, stake-holders stay suspect on delivery to expectation, hence the absence of market-euphoria post sharp fall in CPI below 6.5% and WPI print below 2.5%.

Is down-trend in inflation enough to take a directional U-turn? It is too early to jump to conclusion for sustainability of CPI at lower end of 6-8% and stable WPI at 2-4% when Indian growth momentum is in pick-up phase and best of external tailwinds is seen to be done. Another factor emerges from recent Rupee behaviour for steady weakness from 60 to 63. Given the structural mismatch, sharp decline in 1-12 month term money rates can push Rupee further down over 2014 low of 63.32 into all-time low of 68.80; excessive Rupee weakness will un-do the impact of rate cuts. All taken, it is not a straight-forward case for RBI to cut policy rates in a hurry!

What can RBI do?

Despite any policy action, relevance is on the over-night effective policy rate and build-up of adequate tenor premium (or discount) based on future outlook. RBI intent is seen to be administering effective operating policy rate around mid-point of Repo-MSF rate corridor, currently at 8-9% through restriction in availability of liquidity at overnight Repo counter and quota-limit on term Repo, thereby cutting 100% refinance of excess SLR with Banks to 25%. Despite all these restrictive measures, call money rate continues to trade around 8% Repo rate against RBI's comfort zone of 8.5-9%. Of late, RBI is seen aggressive to suck out liquidity through OMOs and secondary market bond sales.

It is possible that RBI may create room for 50 bps rate cut to satisfy the Government and other stakeholders (policy rate corridor at 6.5-7.5%) retaining MSF rate at 9%. RBI will retain the option to manage effective policy rate at 7.5-9% (or at 7.5-8.5% with parallel shift in MSF rate) through liquidity. It is not difficult for RBI to retain overnight rate at/above 8.5% despite delivering 50 bps rate cut! This stance is seen fair (and prudent) till emergence of clarity in domestic and global cues. All taken, it is still early to turn bullish on Bonds; given the flat yield curve across 1 to 10 years, long term borrowers will enjoy the term discount for cost efficiency, while elevated short term interest rates stay attractive to retail investors. This stance is seen win-win to retain savings rate and borrowing rate affordable to support growth pick-up.

Is Raghuram Rajan listening?

Moses Harding