RBI monetary policy: Central bank raises inflation forecast, bond yield jumps 12 bps

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Mumbai | April 07, 2017 3:44 AM

The yield on the benchmark bond jumped 12 basis points on Thursday to 6.77% after the Reserve Bank of India (RBI) upped inflation forecasts and hinted that there could be upside risks to its numbers.

Although the repo rate was left unchanged at 6.25%, bond markets reacted to the inflation projections inferring the central bank’s stance was a shade more hawkish than in February.

The yield on the benchmark bond jumped 12 basis points on Thursday to 6.77% after the Reserve Bank of India (RBI) upped inflation forecasts and hinted that there could be upside risks to its numbers.

Although the repo rate was left unchanged at 6.25%, bond markets reacted to the inflation projections inferring the central bank’s stance was a shade more hawkish than in February.

While the monetary policy committee (MPC) reaffirmed its CPI-based target of 4% for the medium term, the trajectory is now a tad steeper with inflation averaging 5% in H2 of FY18, and 4.6% in Q4FY19.

“We believe that risks to the RBI’s 4% inflation target and to the RBI’s inflation projection of 5.0% in H2FY18 are to the upside. We expect higher rural wage growth, a narrowing output gap and adverse base effects to push inflation closer to 5.5- 6.0% in H2 FY18,” Sonal Varma, economist at Nomura, wrote in a report.

“These can be seen as interim targets in the journey towards 4%. Had the goal of achieving 4% inflation target been advanced, it would have warranted strong disinflationary bias in the monetary policy. This has now been avoided,” DK Joshi, chief economist at Crisil, observed.

In a series of measures aimed at mopping up liquidity — estimated at close to `4 lakh crore — the reverse repo rate was upped by 25 basis points to 6%. RBI governor Urjit Patel attributed the hike to persistent high liquidity in the system, which demanded a narrower policy rate corridor.

“In either extremely tight liquidity conditions or in situations of persistent excess liquidity, when most market participants are on one side of the market for overnight liquidity, a narrower corridor can contribute to finer alignment of the operating target with the policy rate,” he said. “Accordingly, it has been decided to narrow the policy rate corridor around the policy repo rate to +/-25bps from +/- 50bps with immediate effect.”

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The RBI said it expects liquidity to moderate over the next three to four quarters and stated that it will manage surplus liquidity using a combination of its market stabilisation scheme (MSS), longer-tenure variable reverse repos and open market operations. It is also awaiting a decision from the government on the Standing Deposit Facility (SDF), an uncollateralised liquidity absorption facility, its preferred measure to absorb surplus liquidity.

Some market participants believe the markets may have over reacted. Ananth Narayan, head of financial markets at Standard Chartered Bank, told a television channel, “The RBI raised reverse repo rate from 5.75% to 6%, which could confuse markets in the short run, but in reality, it is not very negative. It is definitely not as negative as a CRR (cash reserve ratio) hike would have been.”

Some sections of the market had anticipated a hike in the cash reserve ratio (CRR), a tool used by RBI in the days after demonetisation to soak up liquidity. A CRR would have hurt banks, as they do not earn interest on funds parked with the RBI.

Liquidity in the system had seen a jump in the weeks after the demonetisation of high-value currency notes, as banks bought government securities with huge amounts they received as deposits. In order to soak up the excess liquidity, the government had in December announced an increase in the limit up to which the RBI could issue cash management bills (CMBs) under the short-term market stabilisation scheme (MSS). The peak level of liquidity absorbed by the RBI reached Rs 7.96 lakh crore on January 4, of which Rs 2.57 lakh crore were absorbed through reverse repos and Rs 5.47 lakh crore through CMBs under the MSS, according to RBI’s monetary policy report for April 2017.

As these MSS bonds began to mature, a situation of surplus liquidity resurfaced in the system.

Patel said the RBI has proposed to the government the introduction of a standing deposit facility (SDF) by amending the RBI Act. The proposal is under examination.

On retention of the central bank’s neutral policy stance, executive director Michael Patra said, “What RBI is signalling is that the move to 4% is going to be challenging. There are no lucky disinflationary forces in the horizon that were there in the past and, therefore, it is in this context that we moved the stance from ‘accommodative’ to ‘neutral’, so that there is no one-way bets on the way in which the RBI moves. So, the evolving outlook will determine how the RBI will move, but it is cautioning you that inflation is elevated relative to where we want it to be.”

The policy statement noted that global developments entail a reflation risk, which may lift commodity prices further and pass through into domestic inflation. In addition, geopolitical risks may induce volatility in the global financial market with attendant spillovers.

In terms of downside risks to inflation, it took note of the recent easing in international crude prices and their pass-through to domestic prices of petroleum products.

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