RBI Monetary Policy August 17

RBI Monetary Policy-August 17

The Monetary Policy Committee of the Reserve Bank of India cut the benchmark repo rate
by 25 basis points to 6% in todays review. This reduction was in line with market
expectations as reflected by the subsequent muted reaction by the bond market.

Falling food price inflation has been the story of the year. The most recent read indicates
food price deflation and the headline Consumer Price Index inflation dropped to a new low of
1.5% in June. What is more note-worthy is that non-food, non-fuel (a measure of core
inflation) has also dropped consistently over the past three months to 4%. The persistent
undershoot of headline inflation and a moderation of core inflation to RBIs target of 4% has
given the central bank room to cut rates.

To be sure, some of this fall in food prices could reverse in the coming months. In particular
prices of pulses and vegetables have fallen by over 15% compared to last year. It is unlikely
that this pace of fall can be sustained. It is much more likely that inflation would revert closer
to the 4% level that is, closer to the core reading. Even achieving a 4% inflation rate by the
end of the current year would be a big win for RBI.

Disinflation has been accompanied by a slowdown in growth in particular in the

manufacturing sector. Some of this could be as a (lagged) result of demonetization last year.
However as the GDP report showed in May, the pace of growth has been falling in each of
the past four quarters.

Lower growth and lower inflation together make a strong case for a rate cut. But even as the
current conditions argue for a strong monetary response, the RBI believes that the near term
outlook is clouded. As explained above it is likely that we have seen the trough of inflation.
On the growth front, the impact of a rate cut on growth might be limited as some of the
slowdown in growth is due to weak balance sheets of banks and the corporate sector. A
reduction in interest rate may not spur lending activity in such a situation.

The overall macro situation is also supported by easy liquidity and an accommodative fiscal
stance. The pace of remonetization has slowed in recent months and excess liquidity
appears to be persistent. This has been supported by strong FPI flows. On the fiscal front,
we have seen the central government hit 80% of its budgeted deficit target in the first quarter
itself. Several states have announced farm loan waivers which could result in fiscal
expansion.

On balance therefore the RBI has opted to cut rates, but has maintained a neutral stance of
policy preferring to wait for further data to decide if rates should be further reduced.

In the near term we expect the markets to remain range-bound. There may be tactical
opportunities in long duration bonds from time to time, though from a structural perspective it
does appear that we are very close to the end of the rate cycle. At the same time easy
liquidity has depressed money market yields. In such a situation investors should consider
short-term corporate bond funds, which are relatively insulated from duration risks but take
advantage of the steep short term yield curve.
 RBI Monetary Policy-August 17

Sources of Data: RBI, Internal Analysis

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