In its first bi-monthly monetary policy review for FY18, the Monetary Policy Committee of the Reserve Bank of India has decided to keep the benchmark policy repo rate unchanged at 6.25%, in line with consensus expectations.
In its first bi-monthly monetary policy review for FY18, the Monetary Policy Committee of the Reserve Bank of India has decided to keep the benchmark policy repo rate unchanged at 6.25%, in line with consensus expectations. This is the third consecutive policy review marked by the status quo on the repo rate, with the last change being delivered through a 25-bps cut in October 2016 policy review. More importantly, the RBI reduced the policy rate corridor, defined by the spread between the MSF and the reverse repo rates, from 100 bps to 50 bps, and also signalling its intent to reduce the current excess liquidity in the banking system to preserve stability in money market conditions.
Is the policy hawkish, or dovish?
Keeping in mind markets’ fascination for avian classification of central bank pronouncements, how does one classify the actions taken by the RBI?
The attempt to accord any avian classification will be inane as long as the monetary policy stance is neutral, something which the central bank shifted to in February 2017. In my opinion, what is important is the assertively optimistic tone underscored by the policy statement.
As per the bi-annual monetary policy report, GVA growth is expected to recover sharply by 70 bps each in FY18 and FY19 to 7.4% and 8.1%, respectively. While anticipated improvement in global demand conditions would form the backdrop, domestic factors like rapid pace of ongoing remonetisation, trickle down impact of recent cuts in bank lending rates, budgetary support to investments, and efficiency gains through implementation of Insolvency and Bankruptcy Code and GST augur well.
Such improvement in anticipated growth is likely to result in a gradual closing of the output gap. This possibility is reflected in RBI’s FY18 average inflation estimate, which appears to be revised upwards to 4.7-4.8% from the implied average of 4.5% provided earlier in February (FY17 average inflation is expected at 4.5%). Thereafter, average inflation is expected to moderate towards 4.4% in FY19. It is noteworthy that the RBI has persisted with its neutral stance despite its own projection pointing towards somewhat higher inflation vis-à-vis the target of 4% over the course of next two years. This shows bounded tolerance for somewhat higher inflation amidst structural and one-off changes like the GST and pay commission awards.
However, in a sign of positive assertion, the RBI highlighted upside risk from high general government deficit compared to international standards, which could get exacerbated by farm loans, something that potentially undermines honest credit culture.
Coagulating liquidity framework
Since the current liquidity surplus of about `4 trillion has been interfering with short term rates in the money market and diluting the monetary policy stance, a policy action was becoming an imperative. The
RBI, in my opinion, has resorted to extracting the best out of the available toolkit by reducing the policy rate corridor. This will lower the extent of undue volatility in a structural manner.
This will be followed by long term variable rate reverse repo auctions. Incidentally, the central bank has already started tapping this and successfully mopped up Rs 760 billion via one month auctions over the last three days. Depending upon the behavioral pattern of currency demand, the RBI could also consider augmenting the tenors of liquidity absorption further to 2-3 months.
This can be supplemented by a re-use of the MSS window (FY18 ceiling has been budgeted at `1 lakh crore), which was deployed successfully between December-2016 and March-2017.
Overall, the policy review sends out important signals on continuity of neutral stance, perseverance of vigilance on inflation, and most importantly the agility and adaptability for expanding the toolkit for managing evolving liquidity conditions amidst ongoing remonetisation.
(The author, Subhada Rao, is group president and chief economist, YES Bank)