RBI Monetary policy: A matter of perspectives

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Published: February 3, 2016 1:09:21 AM

In line with consensus expectations, the Reserve Bank of India (RBI) maintained complete status quo in its sixth bi-monthly policy review.

In line with consensus expectations, the Reserve Bank of India (RBI) maintained complete status quo in its sixth bi-monthly policy review. In the run-up to the policy, a small section of the market was expecting some form of easing, either through the direct monetary channel or via liquidity. However, the central bank stuck to its previous guidance – the ‘wait and watch’ stance.

To get cues for future policy action, one needs to analyse RBI’s policy stance from multiple perspectives.

The inflation perspective

When RBI decided to adopt flexible inflation targeting from January 2015 onwards, it practically waged a war against inflation. This war incorporated many battles with each successive battle increasing in the level of difficulty.

Everyone expected the RBI to win its first battle of 8% inflation target – and it did the same in a thumping manner. The next battle of 6% was also winnable despite inadequate monsoon for two consecutive years as slump in global commodity prices and government’s efficient management of the food economy played an offsetting role. Our projections indicate that the RBI will comfortably over-achieve (~by 50 bps) its target of 6% inflation for January 2016. Going forward, the RBI will face the 5% inflation battle for end FY17.

This is where things will start getting edgy. Further correction in global commodity prices while possible is not likely to carry enough steam. Moreover, the implementation of the 7th Central Pay Commission is expected to provide some upside risk to inflation. While the RBI has indicated that it is ready to ignore any increase in inflation due to technical adjustments associated with the 7th CPC, it would be wary of demand side pressures as the current underlying inflation momentum of 5.0-5.5% is already tracking next year’s target with borderline possibilities. Hence after the 125 bps prompt and anticipatory easing in 2015, the RBI is now likely to get into a reactive mode as far as inflation in concerned.

The growth perspective

Despite substantial monetary easing, revival in growth has been elusive so far. Here the policy adopted by the RBI has been somewhat nuanced. At one level, the RBI has in unambiguous terms communicated the need for maintaining quality fiscal consolidation, something which the government has delivered so far.

However, with additional burden of salaries and pension in FY17, the same task is likely to get challenging. In the upcoming FY17 Union Budget, the government needs to reassert its policy priorities by persisting on quality fiscal consolidation, job creation, and also allow public capex to hand hold private investment in the near term.

Meanwhile, the RBI should look to squeeze the available room for monetary accommodation. We believe a scenario of negative output gap warrants keeping the real policy rate at the lower end of RBI’s indicated band of 1.5-2.0%. In addition, the effort towards cleaning up bank balance sheets and past measures for easing infrastructure financing should complement anticipated structural measures from the government like the Bankruptcy Code in unlocking potential for higher growth.

The financial stability perspective

In an environment of volatility, the RBI has done a commendable job of maintaining domestic financial stability, especially in the currency market. However, the combination of FX intervention, structural currency leakage, and government’s effort to secure fiscal deficit sanctity has culminated in tightness in money market liquidity over the last 2-3 months. This could potentially hamper the extent of monetary policy transmission.

The writer is chief economist, Yes Bank

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