Inflation is estimated in the range of 4.3-4.7% in the third and fourth quarters of the year, including the house rent allowance effect of up to 35 basis points. This estimate is just 10 basis points higher than what was indicated in the October policy
The benchmark yield closed three basis points down on Wednesday at 7.03% after the market cheered a less than expected hawkish tone of the Reserve Bank of India (RBI) on inflation. The central bank indicated in its policy statement that inflation is estimated in the range of 4.3-4.7% in the third and fourth quarters of the year, including the house rent allowance (HRA) effect of up to 35 basis points, with risks evenly balanced. This estimate is just 10 basis points higher than what was indicated in the October policy. The market had its reasons to factor-in a more hawkish tone. Oil prices continue to remain above the $60 levels and the OPEC’s decision to extend its production cuts till the end of next year only added to the worries.
The RBI did mention that inflation will be affected by factors like HRA and oil prices. However, it also stated a few positives, including the fact that despite the recent increase in prices of vegetables, some seasonal moderation is expected in the coming months as the winter farm output arrives. Badrish Kulhalli, head- Fixed Income at HDFC Standard Life Insurance Company, points out that despite concerns emanating from higher crude oil prices, higher food prices and the fiscal push from the government, the RBI balanced its inflation outlook by referring to the output gap dynamics. “The tone of the policy was less ‘hawkish’ than feared, and bond yields have softened from the highs set earlier in the week,” he said.
A section of the market also believes that the central bank is unlikely to conduct more open market operations (OMO) sales. An OMO sale is conducted to remove excess liquidity from the system, while an OMO purchase is done to infuse liquidity into the system. A sale increases the supply of bonds in the system, which usually pushes the yield higher. RBI deputy governor Viral Acharya stated during Wednesday’s policy announcement that liquidity condition is expected to be marginally surplus by end of fiscal year 2017-18. “Given the trends in currency in circulation, it is expected that system liquidity may reach neutrality in the first half of 2018. Of course, these are projections and there are some uncertainties around these. But this is what we see as the likely outcome based on data available,” Acharya said. The central bank has conducted OMO sales worth `90,000 crore so far this fiscal, to suck out the surplus liquidity in the banking system. Sameer Narang, chief economist at Bank of Baroda, explains that the central bank’s expectation of the liquidity getting neutral in the first half of next year is indicative that further OMO sales are unlikely in the near term. “We have to take into account that the RBI had cancelled an OMO sale recently. This shows that the regulator may not be too uncomfortable with the current levels of liquidity,” Narang asserted.