With uncertainty on RBI’s post-MSP-policy response now behind, the market immediately focused upon the embedded tone in the monetary policy communication.
Rate hikes by central banks are seldom followed by a rally in bond and currency markets. However, the third bi-monthly policy review by the RBI, which saw the announcement of a 25 bps rate hike, eventually resulted in comforting market sentiment with domestic bond market and rupee posting gains soon thereafter.
A neutral hike is comforting vis-à-vis a hawkish pause
The August meeting was important as it was the first policy review by the MPC post the government’s Kharif MSP announcements, which recalibrated most of the existing MSPs to 1.5x the cost of production (as indicated in the FY19 Union Budget) for the upcoming procurement season. In addition, the RBI was also in a position to partially analyse the progress of the south-west monsoon with half of the season behind us.
Monsoon performance has so far been close to normal with cumulative rainfall at 94% of LPA (Long Period Average) with reasonably equitable distribution barring wthe East and Northeast regions. However, the market consensus was looking forward to a rate hike from the RBI as the MSP announcements turned out to be much higher than the usual trend – as per our simulations, there is a potential upside impact to headline inflation by as much as 35 bps in H2FY19, followed by another 35 bps upside impact in H1FY20.
Given this backdrop, the actual rate hike turned out to be somewhat of a non-event. Alternatively, in the counterfactual scenario, had the RBI waited for the full assessment of the south-west monsoon (in September) or the actual unfolding of MSP impact (expected in H2FY19), the situation in turn could have necessitated maintaining a hawkish tone with a pause. The concomitant uncertainty with respect to the timing of next rate hike could then have potentially created some volatility in domestic markets.
Guidance speaks louder than rate action
With uncertainty on RBI’s post-MSP-policy response now behind, the market immediately focused upon the embedded tone in the monetary policy communication. This is where the August policy tone became important as it provided a reinforcement of the previous ‘neutral’ stance. Since markets abhor ambiguity, a clear reiteration of the neutral stance provided comfort. Additionally, market participants also drew comfort from the following outcomes:
(a) The MPC voting pattern saw a dilution to 5-1 in favour of a rate hike (one member is likely to have voted for a pause) in August vis-à-vis a complete unanimity for a rate hike in the previous policy review in June.
(b) While RBI upped its inflation forecast marginally (by 10 bps to 4.8%) for H2FY19, it now perceives the risk surrounding its estimates as ‘balanced’ vis-à-vis ‘tilted to the upside’ as alluded to in the previous policy review in June.
The markets also drew comfort from RBI’s reiteration of its neutral stance on liquidity and the reference to the likelihood of acceleration in seasonal currency demand in the economy in H2FY19 in the post policy media conference. This in turn implies room for an offsetting policy action from the RBI. We continue to expect RBI to purchase around `1.5 trillion in g-secs under its Open Market Operations in the remaining part of FY19 to provide durable liquidity support in order to support adequate reserve money growth for ensuring overall GDP growth in the vicinity of 7.4%.
In the near to medium term, after effecting a 50 bps cumulative rate hike in quick succession, RBI is now likely to adopt a wait-and-watch approach while being on a pause for the remaining part of FY19. Data dependence is important in the current backdrop of multiplicity of factors that can impinge upon inflation with possibility of both positive and negative risk outcomes in the near to medium term.
By- Shubhada Rao and Vivek Kumar (Shubhada Rao is chief economist, Yes Bank & Vivek Kumar is senior economist, Yes Bank)